Five Shares to Watch 2022 – second-quarter update

Since we last reviewed our five shares to watch, the economic backdrop has continued to deteriorate, and the level of uncertainty has increased. That means ups and downs are likely to continue.

The ongoing crisis in Ukraine has kept pressure on the supply of key commodities from energy to food, contributing to inflation levels not seen for decades. Central banks have continued to raise interest rates in response and further rises are likely, which normally doesn't bode well for stock markets.

But we've always said investors should take a long-term view. And although this year's shares to watch haven't performed as well as we'd like so far, we think they still offer opportunity. With that in mind, here's a look at where things stand.

This article isn't personal advice. If you're not sure if an investment's right for you, seek advice. All investments and any income they produce can rise and fall in value, so you could get back less than you invest. Past performance isn't a guide to the future.

Investing in individual companies isn't right for everyone – it's higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you're investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Anglo American

First quarter production volumes, and the outlook on costs, were disappointing. That's contributed to a hefty drop in valuation since we last updated on performance, with the shares giving up their gains from earlier in the year.

Covid-19 related absence is still impacting production, as has increased rainfall in South Africa and Brazil. All that contributed to a 10% drop in production over the first quarter, with the outlook for the rest of the year downgraded too.

Given lower production and higher inflation, especially for diesel, costs for the year are now expected to be 9% higher than previously thought. As a result, analysts' expectations for earnings per share over the next 12 months have dropped over 10% since May.

There've also been some disappointing updates relating to the key Los Bronces copper mine. Anglo American has a multi-billion dollar expansion plan underway, giving access to higher grade copper. In May, an environment permit was rejected by Chilean authorities. A review process is underway, but this is a roadblock that the group could do with getting passed sooner rather than later.

Despite the less than positive quarter, we think the longer-term merits of Anglo's diversified mining operation remain intact. Having exposure to industrial and consumer products offers the ability to perform well in lots of different economic conditions.

Plus, exposure to copper and platinum group metals, which are needed for the global de-carbonising effort, offer a future growth avenue.

Commodity prices have come down from last year's highs, but they're still high enough for strong cash generation. Free cash flow's expected to come in around $6.3bn, supporting an 8.0% prospective dividend yield. Remember though, yields are variable and not a reliable indicator of future income.

Despite Anglo's diversification, it's still reliant on commodity prices. And these could come under pressure if an extended economic downturn's round the corner.

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Lloyds

Back at the start of the year, we heard news of a strategy update for Lloyds. Increased focus on digital investment, expanding wealth services and building out small business offerings are just some of the areas targeted for growth.

Longer term we're supportive of that move. But the story in the here and now very much focuses on the UK's dwindling economic outlook and a consumer that's feeling pressures from a cost-of-living crisis.

In the first quarter, the group recognised £177m in impairment charges. A good chunk of that related to having to put extra cash aside to protect against defaults resulting from the cost-of-living squeeze on consumers, and higher cost inflation on businesses.

That charge meant positive moves on net income, specifically net interest income which grew 10%, couldn't flow through to the profit line. Banks make money by lending money out at higher rates than they pay on deposits – the difference is known as the net interest margin. Higher central bank interest rates helped that margin grow to 2.68% in the first quarter, expected to rise further over the year as more rate rises come through.

That's a positive tailwind for this year and one that's unique to Lloyds compared to peers less reliant on interest income. Though it might not have as big an impact as we'd like. Mortgages written during the pandemic came with high margins, but start to expire next year. They'll be renewed at more normal, less profitable levels, offsetting some of the net interest margin growth in 2023.

The wider backdrop is an uncertain one, but one of the main attractions for Lloyds very much remains intact. The group boasts a CET1 ratio, a measure of cash kept for rainy days, well ahead of what's actually required. We'd argue that could be returned to shareholders. But nonetheless, means the balance sheet is in a strong position to help weather any storms. Trading on a price to book ratio of 0.6, the valuation doesn't look too demanding.

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Polar Capital

The tough start to the year's continued for fund management group Polar Capital. Technology makes up 42% of the group's £22.1bn of assets under management (AUM) – the types of assets investors have been staying clear of in the wake of rising interest rates and economic uncertainty. That fed through to a decline in assets under management from its peak of £25bn in early January.

Hitting certain performance metrics and outperforming benchmarks is one avenue of income for Polar Capital. Performance fee profits fell 78.9% last financial year, a product of an exceptional previous year and the difficult market conditions seen in 2022.

On a positive note, core operating profit grew 35% to £69.4m at the full year mark – that's a measure of management fees minus operating costs. The group needs to grow AUM to push fees higher, and signs suggest that's moving in the right direction.

Part of the growth was down to a push into other areas, like segregated mandates, where clients' money is individually managed. Along with more focus on emerging markets, UK value and Europe. The investment case still heavily relies on technology though, and that's an area where we see long-term potential.

There's no denying the outlook from here remains uncertain. Inflation in the UK's predicted to push higher and interest rates are expected to keep rising. There's arguably a good chunk of that uncertainty built into the current valuation, which is below the ten-year average.

With a longer-term view, there's plenty of scope for AUM to grow and profits along with it. Though, volatility in the short term should be expected.

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Smith & Nephew

Smith & Nephew, the medical technology maker specialising in joint replacement, hasn't seen the buoyant recovery we'd been hoping for thanks to deteriorating macroeconomic conditions.

However, we think the recovery's been delayed – not quashed completely. For that reason, we think the market's been somewhat harsh on Smith & Nephew, with the shares down just over 11% since the start of the year. But remember nothing's guaranteed.

First-quarter results suggested top-line growth in the first half will be tepid at best, though the group's still expected to hit full year expectations of 4-5% underlying revenue growth. Low-to-mid single-digit revenue growth doesn't leave much room for error, and given the increasingly gloomy macroeconomic backdrop, any drop-off in demand could throw the group off course.

Given that Smith & Nephew caters toward elective surgeries, this is a concern as people pinch pennies in response to the mounting cost-of-living crisis.

The good news is efficiency drives are paying off – management expects operating margins to improve by 0.5 percentage points this year and climb back to 21% by 2024. If the group can keep this margin expansion on track, it will be in a strong position to make the most of the recovery in elective surgeries.

Inflation threatens to upset the apple cart here though. The group expects its saving initiatives will more than offset rising costs. But as inflation climbs well beyond predictions, we can't rule out some unexpected surprises here.

Notably, the market's not overly excited about waiting around. The group's valuation is well below the long-term average, reflecting the potential pitfalls ahead. With a prospective dividend of just 2.7% on offer, investors will need faith in the long-term recovery. Remember, yields are variable, and no dividend is guaranteed.

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Tate & Lyle

As a reminder, Tate & Lyle's no longer the maker of the golden syrup and sugar it's best known for. Instead, the group's shifted its focus to ingredients like sweeteners and thickeners as well as some larger bulk commodities businesses. Plans to streamline operations and focus on higher growth parts of the business are progressing well.

Tate & Lyle's share price is down nearly 2% so far this year. This is ahead of the broader market, reflecting strong performance in an increasingly uncertain environment.

Full year results were the first under the new structure and the leaner organisation appears to be firing on all cylinders. Underlying operating profit margin came in at 12.4% and is expected to gain, on average, 0.5-1 percentage points per year from here on out. That's despite mounting inflationary headwinds.

Tate's reliant on corn to make its products, and given that's a major Ukrainian export, pricing uncertainty hangs heavy. Luckily the group's been able to pass the brunt on to consumers so far, and efficiency drives have also helped soften the blow. The buoyant market for cleaner, healthier ingredients is also on Tate's side.

However, if prices continue to balloon, it could start to eat into volumes and the group might have to absorb some of these costs at the expense of margins.

The progress at Tate's seen the valuation come up to 16 times expected profits. That's some way above the long-term average, reflecting confidence in the execution of this new strategy. If the group can stay on track through near-term headwinds, we think it's still in a promising position.

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A connected party of one of the contributing analysts holds shares in Lloyds Banking Group plc.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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