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Five shares to watch – third quarter update

A third quarter update on this year’s five shares to watch: DS Smith, WPP, Ibstock, Novo-Nordisk and Keywords studios.

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.

The third quarter was hugely eventful for stock markets and economies around the world. But performance of our five shares to watch remains little changed from the half year stage.

Total return across all five shares remains negative, down 11.3%, as cyclical businesses DS Smith, Ibstock and WPP continue to struggle. However good results from Keywords and Novo Nordisk, and a decline in the FTSE All-Share index of over 20%, mean the five shares remain 8.8% 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 should not be seen as a guide to the future. Yields are variable and are not a reliable indicator of future income.

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.

You can get more comment on the stocks listed here sent straight to your inbox by signing up to research updates.

DS Smith

We’ve only had a short trading update from DS Smith since the half year. Trading has been in line with management expectations – with the group managing to eke out sales growth in August for the first time since the pandemic struck.

The modest growth is being driven by consumer goods and e-commerce customers – more than offsetting weakness among industrial packaging customers.

The good news is that disruption caused by lockdowns to recycling collection has reduced. That’s bringing the cost of recycled paper, a key input for the group, down and together with additional cost savings within the business it should reduce the impact of lower sales on profits.

The return to revenue growth and cost control opportunities have given the board enough confidence to plan a dividend at the half year. That’s welcome news and analysts are currently forecasting a dividend yield over the next 12 months of 4.5%. But, as ever, no dividend is guaranteed and we would caution investors against expecting the same pay out as the company made before the coronavirus crisis hit.

As this crisis has shown, DS Smith is a cyclical business, and its fortunes will rise and fall with those of the wider economy. That’s a potential source of concern as the world looks set for economic turbulence. However, we think the long term drivers of rising e-commerce and the transition from plastic to paper packaging should support the group through. The return of the dividend suggests management agree with that assessment too.


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Ibstock

Ibstock’s half year results in August showed a 36% decline in revenues, with the group falling to an £11m underlying loss.

The revenue decline wasn’t a surprise, with factories temporarily closed in March in response to the crisis, and demand from customers crumbling as building sites were shut. More recently demand has picked up again, but management have still taken the decision to close or mothball three brickworks.

Despite some signs of demand recovering, management are expecting tough times ahead. The current operational base case plans for a 25% fall in demand in the second half of this year and 15% fall in 2021. The worst assumes a 50% fall in the second half and 30% fall in 2021.

Under those conditions a lot will rest on the strength of Ibstock’s balance sheet.

The group saw an underlying free cash outflow of £14.8m in the first half of the year, and that drove a 21.1% increase in net debt compared to the start of the year. That’s less than ideal, and means net debt rose to 1.6 times cash profits – above the group’s long term target of 0.5-1.5 times.

Lenders have agreed to relax the conditions on the group’s debt, and Ibstock had access to over £110m of cash at the end of the half. That gives them breathing space. But if conditions don’t improve, a call for shareholders to stump up extra cash can’t be ruled out.

There are some signs that housebuilding activity has actually held up quite well through the crisis, and the industry is the key consumer of Ibstock’s bricks. The industry will also have destocked in the midst of the crisis to preserve cash, and with activity resuming that could mean a short term increase in pent up demand. Together with more economically insensitive concrete sales (used in large infrastructure projects) that could offer some reasons for positivity in the second half – but we think investors should remain cautious.


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Keywords

Our biggest concern with Keywords is that the shares have done too well – a nice problem to have in the current environment. When we picked our five shares to watch back in November last year, the shares were trading on a Price to Earnings ratio in the low to mid-twenties. Today that’s more like 40.

There are some reasons for the increase in valuation. Underlying earnings per share rose 17.3% in the first half as the group successfully transferred thousands of staff to working from home. With the global gaming industry enjoying a boost from millions of people stuck at home on their sofas, there‘s natural read across for Keywords who are a key supplier to many of the world’s largest studios. However, whether the world and company have changed enough to justify a near doubling in valuation is unclear.

Keywords have taken advantage of the increased valuation to sell £100m of new shares to fund new acquisitions. Since bolt-on deals for smaller studios are a key part of growing both the scale and range of services the group offers, that makes sense.

Since Keywords provides services to games developers, rather than selling games itself, the recent gaming boom is unlikely to have reached it yet. The key challenge from here is making sure the group is able to capitalise on the growth the gaming industry has enjoyed in recent times.


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Novo Nordisk

Novo’s half year results showed steady underlying sales growth of 7%. That might not be setting the world on fire, but dependable high single digit percentage growth is a rarity in the current environment. It’s all the more impressive when you consider that US insulin prices are under a lot of pressure at the moment.

Novo’s North American insulin sales fell 23% in the half, and yet overall North American sales still managed to grow 1%. The difference is mostly made up by rapid growth in the group’s recently launched GLP-1 diabetes treatments. With oral treatment Rybelsus only recently launched, there’s scope for substantial growth in this area for some time to come.

Despite the strong performance Novo remains relatively cautiously positioned, with net cash on the balance sheet rising year-on-year. That gives us confidence in the group’s 2.2% prospective dividend yield. While Novo’s valuation has risen since we picked it, at 22.5 times the rating is far from stratospheric.

Novo isn’t going to shoot the lights out, and the US market certainly presents a challenge in the years ahead. But in our view the company remains very high quality.


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WPP

To say we’ve been disappointed with WPP is an understatement.

As one of the world’s largest advertising groups a sudden global economic downturn was always going to hurt. However, WPP started the year with problems that were both more fundamental and of the group’s own making – with revenues falling in the first two months of the year despite stabilising at the end of 2019.

More recent trends have been better, but the group’s now fighting an uphill battle. Profits for the year have been torpedoed by impairments of £2.7bn, as the value of acquired businesses was written down following the outbreak of the pandemic. First half like-for-like revenues ended up falling 11.5%, despite the second quarter showing some signs of improvement.

Revenues are unlikely to bounce back quickly, despite what the management described as “market-leading new business performance”. After all, companies rarely open the marketing purse strings when times are hard. That makes cost savings the order of the day.

WPP is targeting £700-£800m in savings this year, achieving £296m in the first half. Delivering a more efficient business would improve profitability when revenue growth does eventually return.

On the plus side, the sale of research business Kantar means WPP has some £4.7bn of cash on hand and borrowing facilities. That’s quite a war chest, so we’re not concerned about the business’s survival as things stand. However, long term challenges around the digitisation of marketing are still to be addressed, and together with a gloomy economic outlook that means there could be more pain to come.


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The author of this article holds shares in DS Smith.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. 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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    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.

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