Identifying out-of-favour stocks that have strong recovery potential and sound long-term business prospects can produce high returns for investors. With this in mind, I believe there’s compelling value on offer at FTSE 100 telecoms group BT (LSE: BT-A) and small-cap funeral services provider Dignity (LSE: DTY).
Reset
Dignity was at one time a mid-cap FTSE 250 company. After years of delivering handsome rewards for investors, its share price reached an all-time high of about 2,900p three years ago. Currently, the price is just 540p, up 2.4% on the back of today’s trading update.
What went wrong? In a nutshell, Dignity regularly increased its prices well above the rate of inflation. Ultimately, in the face of rising competition from cheaper and ‘no-frills’ operators, it had to rethink its business and reset its pricing.
Favourable backdrop
Today, the company said: “Funeral market share continued to show a positive response to the group’s updated service offering and price points introduced since January 2018.” The operating performance in the third quarter and year to date was in line with the board’s expectations.
It’s looking like the number of deaths in 2019 (potentially around 577,000) will be the lowest since 2014. However, despite some variance year to year, longer-term run-rate forecasts tend to be reasonably accurate.
On this score, the latest forecasts from the Office for National Statistics – 600,000 deaths in 2020, rising to 740,000 in 2040 – provide a favourable backdrop for Dignity to grow its business.
3 reasons I’d buy
City analysts are forecasting a return to earnings growth (+10%) next year, and the stock can currently be bought for just eight times those forecast earnings. Debt and an investigation into the funeral sector by the Competition and Markets Authority are areas of risk.
However, on balance, the low earnings multiple, the industry’s favourable long-term growth fundamentals, and Dignity’s likely resumption of dividends in due course, lead me to rate the stock a Buy.
Strategy for growth
Like Dignity, BT’s shares were trading a lot higher a few years ago (around 500p) than they are today (190p). Also like the funerals firm, City analysts are forecasting BT to return to earnings growth (+4%) in its next financial year. The stock is trading at a mere 7.7 times forecast earnings.
The company also has a running dividend yield of 8.1%. However, I wouldn’t be surprised to see the payout rebased lower after the current financial year. This is because new management is pursuing a strategy of investing for the long-term growth of the business. In a competitive market, it may require greater investment than currently envisaged. And with the group also having significant debt and pension obligations, a dividend cut may be necessary.
Despite this, and the recently announced loss of a wholesale contract with Virgin Media from the end of 2021, I believe BT’s management is pursuing the right strategy. While there may yet be further short-term pain, I reckon the current low valuation of the stock, the group’s scale, and ownership of both fixed-line and wireless networks, promises long-term gains for patient investors. For these reasons, I rate the stock a Buy at the current level.