Rentokil, ARM and National Grid are excellent contrarian stocks set to soar over the medium term, according to Ardevora’s Jeremy Lang, who believes they all suffer from irrational investor sentiment from previous years’ headwinds that have now passed.
Rather than using a value or growth strategy, the manager looks for stocks for his Ardevora UK Income fund utilising cognitive psychology. He thinks investors, managers, and analysts in financial markets are disposed to making predictable mistakes as well as having inherent biases that create value opportunities.
“Part of what we do is to try and work out where we are in that cycle of [a company’s] over confidence, hubris, denial and acceptance,” Lang said.
It was this approach which has led him to recently buy these three mid-cap stocks, which he thinks investors’ have irrationally turned against.
Rentokil
Lang (pictured) very recently bought this stock, which he says took a turn for the worse about 10 years ago but has now amended for past misdemeanours.
“It used to be regarded as a hard to break, very easy to grow and quality business. It would grow every year by 20 per cent in a way that had lots of free cash flow. Unfortunately all business run out of growth at some point,” he said.
“When this happens, no matter how good they are the incumbent management then attempts to chase growth when it isn’t there and they break them by piling on the risk. That is exactly what happened to Rentokil in the later 1990s and 2000.”
“They embarked on an acquisition spree and bought bigger and bigger businesses that were less and less like their core businesses. Almost 10 years ago, as a result of all those acquisitions, it blew up and the share price collapsed and everyone lost faith them.”
Rentokil’s share price is still down from its 2002 high but has been steadily growing since 2011.
Performance of stock and index over 15yrs
Source: FE Analytics
However Lang says it has a long way to grow further because its recovery has been so slow.
“The trouble is that is has taken them a long time to unravel all that. However in the last year you have seen evidence that the management has finally done enough to unravel past mistakes and accept that past strategies were terrible and moved on.”
“It is working but you have had to wait a long time for that to happen. It is at the right stage of the hubris, overconfidence, denial and acceptance cycle.”
“The risks are now relatively low and the opportunities are relatively high because it still has a lot of stigma attached to it because of that very, very long period when all it did was overpromise and under deliver.”
ARM
Next up, he says this semiconductor business is Rentokil 20 years ago in that he believes it faces a very benign environment when it can easily grow but has been ignored by analysts.
“It is classified as a semiconductor business but actually it has a completely different model to all the other semiconductor businesses. It is really a software company. They have an annuity-like income stream and because it doesn’t actually manufacture the chips, it just designs them, it doesn’t have to keep factories going. It doesn’t really have to do anything to look good and their management is keeping their discipline and doing exactly that,” Lang said.
“It is a very unusual business and because of this it sits within an industry where the characteristics are quite different and it has been quite volatile. It was dominated by businesses that had been riskily run and made people feel nervous.”
“It has a plethora of new growth opportunities above the reason it was successful in the first place. This was because it was a pioneer in design of microprocessors – a computer’s brains – in a way that doesn’t use a lot of power.”
However, the manager thinks investors are not giving the business enough credit because it is so unusual and analysts’ forecasts are hugely underestimating how well it can do over the medium term.
“When it started Intel dominated the market for microprocessors and believed that the more powerful the better. They had the lead on that and no-one could catch up. ARM came at it from a completely different angle and they said while they couldn’t compete on processing power they could build chips that didn’t use very much power.”
“Chips like Intel’s which have a lot of processing power also suck in a lot of energy, which is fine if you’re connected to the grid, but there are plenty of applications where power consumption is a much more important issue.”
“That is why iPhones have ARM chips and not Intel chips because their chips don’t suck in much power and battery life is very important for the iPhone.”
He says ARM is also expanding into new areas but in a way that is very low risk.
“The beauty is that their world is moving beyond just computers and mobile phones and into fridges, cars, etc. Also they don’t have to take the speculative risk of building something but if that chip is successful then they get a royalty.”
National Grid
Britain’s electric grid provider has been ignored of late thanks to a general worry over the energy market despite its long-term income paying credentials and recent backing from the government for expansion of national infrastructure, Lang says.
“It is more of a conventional income stock in the energy sector but it doesn’t generate or sell power. The energy business is quite risky but National Grid just essentially provides the pipes for the electricity around the country and that is a very low risk business – it is like a rent,” he explained.
“However, they are in an industry that is viewed as being high risk and susceptible to changing government rules. But a recent review of it gave it a very clear mandate to invest in its business for a very long period of time because demand is expected to be high some time, especially with the arrival of renewables because every time you put up wind turbine you have to connect that to the grid so the government needs them keep proving more and more infrastructure.”
“This makes them very unusual because they are in the energy sector but have a very clear path to grow and funding that is quite easy. But they appear to be valued and viewed by people as any other utilities firm. It is very low risk and has a very dependable income stream.”
Over the past six months National Grid is down 1.51 per cent while the FTSE All Share has gained 7.4 per cent.
Performance of stock and index over 1yr
Source: FE Analytics