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Five Shares to Watch – first quarter update

We take a look at how our five shares to watch for the year have performed so far this year.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

With lots of uncertainty about inflation, the speed at which the pandemic ends and strength of the recovery in the economy, there are considerable challenges for the rest of 2021.

However, so far this year four of our five shares to watch have delivered positive returns. That's been helped by a rising market more generally. But we're pleased to say that the five shares are, on average, 2.8% ahead of the wider UK stock market.

This article isn't personal advice. If you're not sure if an investment is right for you please seek advice. All investments fall as well as rise 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. Our five shares to watch are for people who understand the increased risks of investing in individual shares. If the 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.

CVS Group

Veterinary group CVS' half year results, announced at the end of March, showed a healthy 9.4% increase in revenues and a 38.3% increase in underlying profits before tax.

That growth reflects the spectacular increase in pet ownership over the pandemic – with CVS' new client registrations up 17% in the previous 6 months. Together with increasing average spend per pet, that bodes well for the long term. Pets are for life, as the saying goes, and more pet owners prepared to spend more money should be a lasting tailwind for the group.

A focus on working capital management led to a strong free cash flow generation, up 79% year-on-year. While that's likely a one-time boost it's allowed the group to substantially reduce net debt (readily available assets minus debt), which positions it well for possible acquisitions in the second half.

Free cash flow is the net amount of cash generated from operations minus the amount spent on capital expenditure.

One note of caution though. A very strong share price performance since the start of the year means the shares now trade on a price to earnings (PE) ratio of 28.8 times profits. That's well above the ten-year average of 17.8 times. Long term we still see opportunity, but the risk of a de-rating and share price fall if numbers disappoint is very real.

A common valuation measure that divides the share price by profits per share. So will rise if prices increase or expected profits decrease.

Stands for ‘Price to Earnings Ratio'. Ratios should not be looked at in isolation.

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Diageo's half year results back in January showed reasonably positive results – with underlying sales growth of 1% thanks to market share growth in the off-trade.

Still, the closure of hospitality venues around the world and collapse in travel demolished sales in bars and departure lounges where Diageo traditionally earns better margins. As a result earnings per share fell 15% year-on-year.

Weaker profits this half do make the debt position look intimidating, with net debt equal to 3.4 times profits. That's well above the 2.5-3 times target range, and we suspect was the main reason for scrapping the share buyback programme. Without profits growing again that will remain a concern – and might ultimately affect dividend growth too.

However, the group's optimistic about the prospects for sales once the economy starts to reopen. Consumers have spent much of 2020 and early 2021 cooped up inside, and those still in jobs will likely have put aside considerable savings. We think that bodes well for the premium spirits category in the near term. We suspect the group could be on course for a bumper summer – which was a key reason for its inclusion in our five shares to watch. Although of course there are no guarantees.

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Facebook's full year results reported 33% growth in revenue and operating profits rose 44%.

But despite those knockout numbers the shares trade on a PE ratio of 24.8, 22.5% below the company's average since listing. That's because the main concern at the moment isn't so much with Facebook's operating performance – where user numbers and revenue per user continue to tick along nicely – but with the regulatory landscape in which Facebook operates.

In Europe, the US and the UK, regulators are taking an increasingly tough line with large tech groups on issues like data protection, user content and competition. That's led to worries that Facebook could be broken up – forced to sell off WhatsApp or Instagram, or both – or face new rules that fundamentally undermine the way the social media giant makes money.

We think Facebook's businesses are strong enough that even after any enforced separation they would be able to thrive. However, these are very real concerns, and investors must make up their own minds on how tough regulators will ultimately be.

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Ibstock's full year results showed a 23% fall in revenue and 86% fall in underlying profit before tax. That reflects the ‘operational gearing' in the business – where a high fixed cost base means falls in revenues are magnified at the profit level.

However, operational gearing works both ways. Should sales recover going forwards, profits could also bounce back quickly. In fact, Ibstock has made significant progress in delivering cost savings during the pandemic – which at one stage seemed crucial to survival. That sets it up well for a return to business as usual.

Demand for the group's brick and concrete products has recovered faster than management initially expected. With house sales and prices remaining robust in the early months of 2021, we think the outlook for long-term demand for Ibstock's products is good.

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Tesco has completed the capital return from the sale of its Thai and Malaysian businesses. Together with the sale of its Polish business means the group is now more focused on the UK than ever.

The group reported very strong Christmas trading – with 6.3% year-on-year growth in the UK & Ireland. Unsurprisingly online growth was a big driver – up 80% in the third quarter adding nearly £1bn of sales. However, the big unknown at the moment is how profitable all these extra sales will prove.

Extra costs associated with the pandemic have been high, and Tesco bank in particular had been hit hard by provisions for bad loans and less spending activity. All of this will eat into full year profits.

Long term however, we think the investment in digital expansion will prove crucial for the group. It more than doubled its online delivery slots to 1.5m a week in the first half alone. If Tesco can continue to convert its position as the UK's leading grocer into a robust online delivery business, then it has scope to increase sales substantially.

HL's non-executive chair is also a non-executive at Tesco.

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This article is not personal advice or a recommendation to buy, sell or hold any investment. If investors are not sure of the suitability of an investment for their circumstances, they should seek advice. 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. 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 and investments rise and fall in value so investors could make a loss.

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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