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Five shares to watch 2023 – fourth quarter update

As 2023 becomes a memory, we check in on how our five shares to watch have performed in the final quarter.

Important information - 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.

As interest rate cuts are becoming even more likely, markets have ended 2023 on a more hopeful note. But it wasn’t all good news, with increased Middle East tensions over the last three months of the year.

And while hopes are growing for a US soft landing, growth expectations for the UK and Eurozone have been pulled back. Here, we look at how our five shares to watch for 2023 have got on in this complicated landscape.

This article isn’t personal advice. Investments and any income from them can fall as well as rise in value, so you could get back less than you invest. If you’re not sure if an investment is right for you, seek advice. Past performance isn’t a guide to future returns.

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.

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BAE Systems

BAE Systems sits in a key space in the defence market, helping the group to comfortably outperform the broader market over 2023. November’s trading update repeated its full-year targets, with sales and underlying operating profits expected to grow 5-7% and 6-8% respectively.

Demand for BAE’s products and services has flown in over 2023, adding more than £30bn to the order book at the last count. And with raised tensions in the Middle East, we expect this figure will be higher by year-end.

This backlog of work gives good revenue visibility, but keep in mind that profitability hinges on predicting future costs. Longer-term contracts mean the risks and costs can change over time, so there’s plenty of trip hazards if the group loses focus.

The big story of the year was its $5.55bn acquisition of Ball Aerospace, which looks like a good fit to us. Ball has unique positions in critical space and nuclear deterrence technologies. Clearance is moving along and the deal’s set to complete in the first half of 2024.

Initial expectations were that this would add more than $2bn to BAE’s annual revenues. But if expertise and resources can be used effectively, we see that figure potentially rising by two or three times as much, although there are no guarantees. BAE Systems is still one of our preferred names in the sector heading into the new year.

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British American Tobacco

British American Tobacco's (BATS) 2023 organic revenue growth is now expected to come in at the bottom of the 3-5% range, as US combustible sales stay under pressure. That’s seen pressure on the valuation over 2023. And while these headwinds are likely to continue in the new year there’s still room for hope.

New Categories are expected to have been broadly breakeven last year, two years earlier than originally thought. The group has set a punchy goal for non-combustibles to drive 50% of revenues by 2035. We see regulatory scrutiny as the biggest potential blocker here.

Our case for BATS centred on its strong cash generation. With expected cash conversion of close to 100% we still think the company’s well placed to make the necessary investments to keep pivoting away from cigarettes.

It also leaves room to support an attractive dividend yield, which is now in double digit territory after a steady decline in the company's market value. As ever though, there are no guarantees and yields are not a reliable indicator of future income.

The weakness in the valuation suggests that there's still a job to be done in convincing investors that New Categories can underpin BATS' future. Successful execution of the strategy could well drive a re-rating, but it won't be an easy task.

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Bunzl put in a good showing in the final part of the year, ending comfortably ahead of the broader market over 2023. December’s trading update gave a welcome push in the right direction, with management raising profit guidance and a slightly more upbeat 2024 outlook than markets were expecting.

But finding organic growth has been a challenge throughout the year, with revenue expected to fall 1-2%. Bunzl tends to benefit from inflation as it can pass it on to consumers, boosting revenue. So, the fall last year has been a headwind compared to the year before, as has a drop in Covid-19 related sales.

Despite that, the strengths of this business are in its strong and essential product range (think food packaging and safety equipment) and its highly cash-generative model. This lets it self-fund expansion through acquisitions. Bunzl’s a mashup of smaller businesses, so acquisitions are key.

We were also impressed to see margin expansion even with the softer revenue performance. That tends to be a sign of a well-run business with control over its operations.

The key thing to watch is how organic growth plays out from here, continued weakness in this area puts added pressure on acquisitions to do the hard work. Still, for longer-term investors, we’re still supportive of the name.

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PayPal’s third quarter revenue came in at $7.4bn, with underlying growth of 9% – ahead of market forecasts. Its fourth quarter revenue growth is expected to land between 7-8%. But full year underlying operating margin expansion guidance was still lowered for the second time last year.

Cost cutting can only go so far to offset the lower margin contribution from the unbranded business, Braintree, where the company is purely a payment processor.

But there is some hope that it won’t keep aggressively discounting like we’ve been seeing. There’s also a plan to revive growth in the higher margin branded business, which leverages the iconic PayPal button. Even though it’s a popular name with consumers, the customer journey has been a little behind the times.

Enter a new improved one-click button that’s being bundled with Braintree. But while Braintree is mainly focusing on bigger merchants, the PayPal branded business is more focused on small and medium-sized businesses.

Launching a processing solution for smaller companies last year has given a chance to reengage PayPal’s target retailer market and shore up growth in branded revenues.

With the valuation well below the long-term average, the market’s not expecting a huge turnaround. We still see structural growth drivers for the digital payments industry, mixed with impressive market share, as an attractive proposition. But PayPal needs to keep modernising its solutions to keep up with the competition.

Remember, before you can trade US shares, you need to complete and return a W-8BEN form.

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Truck and equipment giant Volvo Group has seen its valuation rise around 36% last year. That’s come from a combination of better-than-expected results and strong handling of a tough inflationary landscape. Past performance is not a guide to the future.

The group’s third-quarter sales rose 9% to SEK132.4bn, ignoring the effect of exchange rates. Underlying operating income was SEK19.1bn, up from SEK11.9bn.

The positive development comes as supply chain issues and higher costs from things like labour, production and transformation-related costs were offset by higher prices. This helped underlying operating margins rise more than four percentage points to 14.4%.

The last quarter hasn’t been without challenge though. Free cash has spun to an outflow. This is partly because of normal seasonal patterns of Volvo’s cash flow – the nature of the business model means this is quite lumpy. The group’s confident that efforts to right-size inventory will help things stabilise and we’re cautiously optimistic, but it will need watching.

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We’re also keeping an eye on the economic landscape. Sharp economic downturns would hurt Volvo, and we’re already seeing some more cautious ordering activity.

Ultimately, Volvo’s very high barriers to entry and steady-Eddie nature are still intact in our view – which also helps underpin the 4.3% dividend yield. We do wonder if the valuation has started to look a little less compelling though. Remember, no dividend is ever guaranteed. Overseas dividends can be subject to withholding tax which might not be reclaimable.

A member of the Equity Research team holds shares in BAE Systems.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views might have changed since then. Unless otherwise stated, estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates aren’t a reliable indicator of future performance. Yields are variable and not guaranteed. 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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Published: 3rd January 2024