Why Topps Tiles plc could be a contrarian bargain

Shares of Topps Tiles (LSE: TPT) rose by 5% this morning, after the retailer said that like-for-like sales rose by 4.2% to £215.0m at last year.

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Although the group's peers in the building materials sector have generally had a poor year, Topps is doing well. Adjusted pre-tax profit rose by 7.8% to £22.0m during the year to 1 October, while cash generation from operations rose by 23.5% to £29.9m. Shareholders will receive a final dividend payment of 2.5p, 11.1% higher than last year.

What's more surprising is that the outlook remains positive. Topps' like-for-like sales have risen by 0.8% since the start of October. Although this is less than the 3.3% like-for-like gain reported for the same period last year, it's not bad.

In this article, I'll ask whether investors might be able to profit from low stock valuations in the housing market. Is this a contrarian play, or are things about to get worse?

Clever strategy

Topps Tiles' strategy of targeting trade buyers seems to be paying off. The group's gross profit margin rose from 61.2% to 62.9% last year. Trade sales now account for 52% of all sales, up from 50% last year.

The company says it is seeing a trend towards "do it for me", rather than DIY. Investment in new ranges and a trade loyalty programme mean that more and more homes are being decorated with Topps' tiles.

Financially, Topps looks attractive. The shares trade on a trailing P/E of 9.9. The trailing dividend yield of 4% was covered comfortably by both earnings and free cash flow last year.

The big risk is that the market will soon start to slow, leaving Topps with an expanded store network and falling sales. The fixed costs of operating 352 shops would mean that profits could fall very fast if sales weaken.

However, there's no sign of this yet. Topps' shares have risen by 5% following today's results, but still look cheap. The stock trades on a forecast P/E of 9.4, with a prospective yield of 4.7%. If you're optimistic about the 2017 outlook for the UK economy, then Topps Tiles could be a smart buy.

A big contrarian position

Topps Tiles may carry some risks. But London-focused housebuilder Berkeley Group Holdings plc (LSE: BKG) is a much bigger contrarian play. There's clear evidence that the top end of the London housing market is slowing down.

In Berkeley's most recent trading update, the group said that reservation levels this year are running about 20% below those seen last year. Despite this, Berkeley remains confident of delivering £1.5bn of pre-tax profit over the next two years.

So how should we value Berkeley? One option is to consider the group's dividend plans and its book value. Berkeley's last-reported book value per share was 1,311p. The group also plans to return 1,000p per share to shareholders through dividends by September 2021. Together, these suggest that the current cash value of Berkeley shares is about 2,300p.

Berkeley shares currently trade slightly above this level, at about 2,500p. In my view, this valuation is probably about right, given the uncertain outlook. Things may get worse before they start to improve. But if you're more bullish than me, then Berkeley's 8% yield may be worth a closer look.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has recommended Berkeley Group Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.