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A favourite technique of many seasoned investors looking for gains from a sector on the rise is to invest not in the sector’s producing companies, but in shares of the companies that supply the producers.

As an example, prior to the massive run-up in the price of gold and other precious metals, savvy investors bought shares in mining companies that supplied the minerals, not in actual gold or silver.

It is hardly a well-kept secret that the demand for raw materials extracted from Australian mines is booming. In last week’s sector scan column on TheBull, Mike Bigwood of Patersons Securities gave us five resource service companies that stand to benefit handsomely from continued demand for Australian commodity minerals. He also added the necessary caution that a general downturn in the demand for commodities would not be good for these companies.

Of the five shares on his list, Bigwood expressed high confidence that Decmil Group (DCG) is currently undervalued by Australian investors. So let us take a look at DCG, by the numbers.

Although these resource services companies are classified as industrials, there is a great deal of variation in the kinds of services they provide.  Consequently, it is extremely important to select a company that offers similar services as a comparison. DCG is a design and construction firm that offers “non-core” services, such as the design and construction of miner lodgings and warehousing facilities. They leave the pipeline construction to other suppliers.

The company on Bigwood’s list that most closely resembles DCG is Forge Group (FGE). Although we will use FGE as a primary competitive comparison, we are also going to take a look at Leighton Holdings (LEI), Australia’s largest engineering services contractor.  They serve global markets in a variety of industries and have a market cap of about 7 billion.  Why do we want to include this share?  Take a look at a 1-year chart, comparing share price performance of LEI against our target share, DCG:

#FOTO:1060:400#

Bigwood selected smaller, newer, companies for his list, believing they have more room to grow than larger, more established companies.  The chart clearly supports his rationale.  What’s more, for those of you who know the beliefs of some of the world’s great investors, you will recognise the maxim – big companies do not make big moves, courtesy of Peter Lynch, legendary fund manager.

As further evidence, here is a 1-year chart comparing FGE with a market cap of about 440 million, and DCG, with a market cap around 380 million:

#FOTO:1061:400#

Although both companies made substantial upward moves, FGE appears to have outperformed DCG, based on share price alone.  Bigwood likes FGE, but seems more enthusiastic about the long-term prospects of DCG.  Let’s look at some numbers to see if we can understand why.

Profitability Ratios/Dividend Yields

Profitability is perhaps the most important reason for investing in the share market.  Profitable companies should appreciate in value, and some highly profitable and secure companies pay dividends as well.  So here is our first set of numbers for DCG, FGE, and LEI:

  DCG FGE LEI
ROE (Return on Equity) 24.63 41.57 22.55
ROA (Return on Assets) 13.41 24.5 6.76
Dividend Yield 0 1.5% 5.1%

 

All three of these companies are showing outstanding returns, with FGE the leader by a healthy margin on profitability.  What’s more, FGE pays a small dividend, which DCG does not. 

If you are familiar with the conventional wisdom that an ROA of 5% or above and an ROE of 15% or above represents a good investment, the numbers for these three companies might seem high.  You also know, however, that there are differences in these ratios across industries.  We took a moment to look at the ROE and ROA for a few of the other shares on Bigwood’s list and they are also higher than the conventional standard. 

Liquidity and Debt Ratios

Liquidity ratios measure the company’s ability to convert assets into available cash to meet short-term (less than one year) obligations.  Ratios under 1.0 are generally cause for concern.

Debt is what makes liquidity important.  While it is always advisable to use “other people’s money” where feasible, too much borrowing can be dangerous.  The debt to equity ratio shows the relationship between borrowed money and owner money, or equity.  Higher ratios indicate higher borrowing.  Here are the numbers for our share comparisons:

  DCG FGE LEI Sector
Current Ratio 1.47 1.82 .77 1.59
Quick Ratio 1.10 1.45 .67 1.04
Debt to Equity 20.3 27.2 74.8 N/A

 

Generally speaking, construction industries are considered capital intensive, meaning they need large amounts of cash to finance ongoing operations.  High Debt to Equity ratios are common in capital-intensive industries.  The debt to equity ratio for both DCG and FGE are in line for the industry and their liquidity ratios are adequate.

On the surface, the numbers for LEI do not look very good.  However, big companies frequently carry more debt along with low liquidity. 

Market Valuation Ratios

Market valuation ratios show what the share market community as a whole is willing to pay for a company’s shares.  Of all the financial ratios investors can use to evaluate shares, none are as widely used as valuation ratios. 

Growth investors love them because they indicate the market is expecting growth and is willing to pay for it.   Value investors love them because they can spot shares worth more in fundamental value than the market is willing to pay.  Here are our numbers:

  DCG FGE LEI Sector
Price to Earnings (P/E)  15.57 11.28 17.55 12.78
Price to Earnings Growth (PEG) .16 1.08 10 .75
Price to Book (P/B) 4.31  4.49 2.78 1.25
Price to Sales (P/S) 1.19 1.69 2.75 .56

 

One number in this table confirms Mike Bigwood’s belief that DCG is undervalued – the Price to Earnings Growth ratio.  The PEG ratio takes future growth into account with a perfectly valued stock having a PEG of 1.0.  Such a ratio means the share’s P/E ratio equals its growth rate.  Companies with low growth expectations have higher PEG ratios, like the 10.0 for LEI.  Many investors view any share with a PEG of .5 or below as a strong buy – and DCG has a PEG of .16

As you know, it is never a good idea to base a buy decision on one ratio.  However, up to this point, the only case to be made for investing in DCG rather than FGE is the PEG ratio.  If anticipated growth is the reason for selecting DCG, let’s stop for a moment and look at DCG’s performance, year over year.

Year over Year Performance

Whenever possible, the numbers you analyse should be the most current.  Decmil reports annual earnings at the end of June 2011 for fiscal year 2010.  For this table, we used their Half Year (HY) reporting to December 2010.

  HY2011 HY2010 %Change
Revenue 233.7m 149.2m +57
Net Profit after Taxes (NPAT) 14.2m 9.0m +45
Earnings per Share (EPS) 11.43cps 7.47cps +53

 

Decmil Group has grown revenue and earnings per share by more than 50% and net profit after taxes very close to 50%.  While these numbers when coupled with the PEG paint an enticing picture, let’s see if there is more we can learn by looking behind the numbers

>>Back to the newsletter to view other articles – June 5th 2011  

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.