Sometimes the stock market over-reacts to some bad news, providing contrarian investors with an opportunity to snap up a bargain. Today I'm going to look at two potential turnaround buys.
This sell-off may have gone too far
Until recently, over-50s insurance and travel group Saga (LSE: SAGA) had been seen as a fairly safe investment. But the firm's shares have fallen by 38% since it shocked the market with a profit warning in December, slashing forecasts for the current year and warning of tougher trading conditions in its insurance business.
What's most interesting about the stock's recent collapse is that broker consensus profit forecasts have only fallen by 6% to date.
There are two ways to interpret this situation. The first is that the market sell-off has gone too far. Trading on a P/E of 9 and with a covered dividend yield of 7.6%, the shares could be too cheap to ignore.
Alternatively, there's a risk that forecasts don't yet factor in enough bad news. Analysts' forecasts often lag behind events, and management guidance commonly underestimates the scale of the problems which lie ahead. This is why profit warnings often come in threes.
My biggest concern is Saga's insurance business, which generated around 90% of pre-tax profit last year. December's update suggested to me that insurance profits could be lower in future.
A second concern is that profits are expected to fall again in 2018/19. One of the rules used by legendary growth investor Jim Slater was that you shouldn't buy turnarounds until profit forecasts show a return to growth.
I believe it makes sense to stay on the sidelines, at least until Saga's final results are published in April.
This turnaround is up 15% today
Another recent faller is car dealership group Pendragon (LSE: PDG). The shares enjoyed a 15% gain this morning, but are still worth 25% less than they were at the start of October.
To adapt to falling new car sales, the firm plans to double used car sales by 2021 while also focusing more heavily on aftersales and its software business. Management hopes to raise £100m by selling the group's US car retail business and save £100m by reducing the number of premium franchises in the UK.
These changes seem sensible to me and today's 2017 results suggest that the business is now moving in the right direction.
A contrarian buy?
Like-for-like used car revenue rose by 15.3% last year, while aftersales revenue was 6.9% higher. Although new car revenue fell by 4.9% on a like-for-like basis, software revenue was 9.7% higher, and leasing revenue grew by 39%.
Group revenue for the full year rose by 4.5% to £4,739m, but lower margins on car sales still caused pre-tax profit to fall by 10.5% to £65.3m. Adjusted earnings were 15% lower, at 3.3p.
Despite this, there was good news for dividend investors, who will see their payout increased by 6.9% to 1.55p per share.
After today's 15% share price gain, Pendragon boasts a forecast P/E of 6.9 and a prospective yield of 6.5%. I think this could be a solid income buy, despite the risk of a downturn in car sales.
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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Pendragon. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.