In a market corrections people do not tend to be discriminating in their investment decisions. Good and bad stocks are sold with little regard for their relative merits. This creates opportunities for savvy investors to potentially snap up quality stocks at lower prices than they traded only a few weeks ago.

It is worth noting that UK stocks had already been lagging the performance of other major markets before the current market sell-off.

In the 12 months to 1 February 2018 (just before the market correction began) the FTSE 100 was up just 5.4% against a 25% gain in the FTSE All-World index of developed market stocks.

Since the global sell-off began at the start of February, the FTSE All-World has fallen by 7%, and the FTSE 100 is down 4.3%.

There are numerous examples of great companies that look appealing following a recent decline in their respective share prices. We will discuss six of them later in this article.

We’ve only picked firms with a good record of creating shareholder value as measured by decent levels of return on capital employed and a price-to-earnings (PE) ratio below 20. We then narrowed the field by only looking at stocks which had fallen in value between the market close on 1 February to the morning of 12 February, when this article was written.

Before we discuss our six stock picks, it is worth taking a step back to consider a few important points when trying to spot potential bargains amid stock market weakness.

A SELECTIVE APPROACH

You need to be selective, even after applying strict criteria to your stock market search. For example, building products firm Marshalls (MSLH) ticks many of the boxes we want from a stock at present, but we would be cautious about investing in it at the moment given the poor state of the UK construction market which it serves.

You may also need to be patient. After a long period of limited volatility, seesawing markets have returned which means recoveries in share prices are unlikely to occur in a straight line. However, if you pick the right stock then you could set yourself up for strong returns in the long run.

FASHIONABLE STOCKS LOSING MOMENTUM

Investors need to be particularly careful with previously fashionable stocks, particularly in the small cap space, which were among the biggest victims in the recent market weakness.

Many of these companies continue to trade on high PE ratios even after recent weakness. The PE essentially tells you how long it will take for a company’s forecast earnings to cover the price you paid for its shares.

In buoyant markets, investors can be willing to disregard the PE if they can see potential for earnings growth but when sentiment sours they will be less willing to pay for ‘jam tomorrow’.

The accompanying table shows how the best performing stocks pre-market sell-off (based on one year share price rise) have performed since the markets turned at the start of February.

Many of these companies are still attractive investments. However their previous stellar share price gains makes them obvious choices for profit taking by investors wanting to lock in gains in case of another bout of share price weakness. Therefore you should be prepared for potential volatility in their share prices near-term.

What is the Vix?

Volatility has returned to the stock market and has prompted many investors to be worried about their equity holdings (another word for stocks and shares).

You can monitor the level of volatility by looking at the CBOE Volatility Index, better known as the Vix. It is calculated and published by the Chicago Board Options Exchange. Type the ticker symbol ‘VIX’ into Google Finance to see the latest level.

The Vix is a shorthand gauge of investor fear, measuring the market’s expectation of 30-day volatility on the S&P 500 index, as implied by the price of near-term options.

Quoted in percentage points, the current level is 29.06. The Vix predicts a probable range of movement over the next 30 days.

On 6 February 2018 the index hit 50 and in autumn 2008, at the height of the financial crisis, the Vix topped 79.

DON’T ASSUME EVERYTHING WILL TRADE AT PREVIOUS LEVELS

You should also be very wary of buying companies which previously enjoyed strong momentum.

Just because stock X traded at 100p before the sell-off there is no guarantee it will automatically return to that level.

Instead you may wish to focus on companies which generate excellent returns on capital and do not trade at excessive valuations relative to their peer group or historic averages.

You should also consider if the concerns behind the current correction, namely inflationary pressures in the US and the withdrawal of cheap credit, will impact your prospective investment.

This is particularly relevant for businesses with significant borrowings or those which would struggle to pass higher costs on to their customers through higher selling prices.

Let’s now discuss the six stocks we’ve spotted as being attractive investments in light of recent share price weakness.

SIX STOCKS TO BUY NOW

IMI (IMI) £12.45

Share price movement since 1 Feb (night before US market triggered global market sell-off): -6.5%

Forward PE: 19.1

Industrial engineer IMI (IMI) has been busy making improvements to its business since late 2014 to cope with higher organic growth and that’s started to be reflected in the earnings expectations. Several analysts were upgrading earnings forecasts in late 2017, saying IMI should see the benefits of its work start to come through in 2018. Its end markets are also looking healthier.

IMI has three divisions. Its ‘Critical’ arm provides critical flow control solutions that enable vital energy and process industries to operate safely, cleanly, reliably and more efficiently. The focus in ‘Critical’ has been on value engineering, footprint consolidation and project management.

Its ‘Precision’ arm is the largest division by revenue and specialises in developing motion and fluid control technologies for applications where precision, speed and reliability are essential. IMI has been simplifying the supply chain and product range.

The third and smallest division by revenue is ‘Hydronic’ which supplies products for hydronic distribution systems which deliver optimal and energy efficient heating and cooling systems to the residential and commercial building sectors. Here, IMI has been introducing new products.

After seeing pre-tax profit fall by nearly 5% to £208m in 2016, analysts expect the figure to come in at £223m in 2017 and £249m in 2018.

Morses Club (MCL:AIM) 126.75p

Share price movement since 1 Feb (night before US market triggered global market sell-off): -6.8%

Forward PE: 11.1

The small cap specialist lender has a great track record of delivering superior returns and is now well placed to benefit from problems depressing its larger rival, Provident Financial (PFG).

Return on capital employed (ROCE) was 27.7% in the year to February 2016 and 25.8% in 2017, according to stockbroker FinnCap. It forecasts Morses Club’s ROCE will be 22.1% in 2018, 25.7% in 2019 and 27.7% in 2020.

Return on capital employed is a financial ratio that measures a company’s profitability and the efficiency with which its capital is employed. A figure above 15% is generally deemed to represent a great business, as long as those returns can
be sustained.

Historically Morses Club has grown its loan book by acquiring books from smaller operators who are often retiring. FinnCap said last October that as the forces of technology, regulation and legislation increase, small operators will find it harder to exist in a sub-scale form. ‘We believe that Morses Club is well placed to consolidate these players,’ it added.

Morses Club has a policy of keeping loans to short-term durations; the average was 41 weeks at the 2017 year end. ‘Shorter-duration loans carry higher cash and income yields, while also having lower impairments and consequently result in a higher return on equity,’ says FinnCap.

Next (NXT) £47.65

Share price movement since 1 Feb (night before US market triggered global market sell-off): -5.7%

Forward PE: 11.5

Risk-tolerant investors should buy the latest dip at cash-generative clothing-to-homewares retailer Next (NXT). Sentiment towards the one-time stock market darling is gradually recovering.

Sentiment previous soured on concerns over subdued consumer demand.

However, Next last month delivered a marginal upgrade to profit guidance for the year to January 2018 with its Christmas trading update. It highlighted improved performance over the peak festive season from both the retail store and online channels.

Despite being cautious on the outlook, Next has committed to spend another £300m on share buybacks in the current financial year to January 2019, implying that it thinks its shares are cheap.

It is also worth noting that sterling’s recent strengthening is a boon for Next’s margins, while the Bank of England’s marginal upgrade to UK economic forecasts and more bullish view on wages could also be good news, albeit rising interest rates would be unhelpful for those indebted and already hard-pressed consumers.

Redde (REDD:AIM)

Share price movement since 1 Feb (night before US market triggered global market sell-off): -6.7%

Forward PE: 14.0

Bath-headquartered Redde (REDD:AIM) provides a range of accident management and legal services to motorists and insurers.

Strong profitability and cash flow since a turnaround of the business that completed in 2013 have helped underpin a generous dividend policy. Based on consensus forecasts the company yields more than 7%.

By handling aspects like courtesy cars after an accident, Redde frees up time and money for its insurer partners and allows them to focus on what they do best – underwriting risk.

The company also helps maximise the potential for customers to renew their policies by offering an efficient and straightforward service.

Redde is attracting new partners and is deepening its relationship with existing clients. According to stockbroker N+1 Singer, key competitors have fallen away or are seeking
other strategic goals. This should help the company sustain double-digit returns on capital
in the future.

ZPG (ZPG) 328.4p

Share price movement since 1 Feb (night before US market triggered global market sell-off): -4.9%

Forward PE: 18.3

Online property and price comparison specialist ZPG (ZPG) generates strong returns from its Zoopla property site which still accounts for the lion’s share of its revenue.

Zoopla charges estate agents for listing properties on the site. The company achieves strong margins and healthy cash flow and has limited overheads. This drives an impressive return on capital employed of around 20%.

Estate agents have attempted to cut out the middleman through the recently-floated challenger portal OnTheMarket (OTMP:AIM). We don’t see it as worrying competition to Zoopla. OnTheMarket does not offer the fullest view of the inventory of homes on the market and so risks being ignored by prospective buyers and, as a result, could be of limited use to agents.

ZPG has been busy adding comparison and data services to its portfolio including utilities and money, thereby broadening its reach to a greater number of consumers.

Investment bank Liberum previously estimated the cross-selling opportunities created by this ‘one-stop-shop’ approach could be worth £3bn in extra revenue.

After a failed £460m bid for GoCompare (GOCO) last year, ZPG is gearing up for more acquisitions by issuing £200m in new debt and agreeing a £200m lending facility. Increased indebtedness is therefore a potential risk factor if borrowing costs increase.

GVC (GVC) 884.5p

Share price movement since 1 Feb (night before US market triggered global market sell-off): -3.8%

Forward PE: 15.4

Growth and income-hungry investors should use the small pullback at gaming consolidator GVC (GVC) as a buying opportunity.

GVC has sealed the audacious takeover of betting shops operator Ladbrokes Coral (LCL) in a deal creating a merged entity big enough to enter the FTSE 100.

Isle of Man-headquartered GVC, behind the Foxy Bingo, Bwin and Sportingbet brands, will own 53.5% of the enlarged gambling giant, with CEO Kenneth Alexander earmarked for the hot seat.

Alexander will lead a fast-growing, diversified, international online and retail sports betting behemoth with more than 90% of its net gaming revenue generated from locally regulated/taxed markets.

Encouragingly, GVC has a strong record of creating value from acquisitions, having bought Sportingbet in 2013 and Bwin.Party in 2016. Gaming companies are seeking greater scale in an industry that is shifting online and facing rising regulatory and tax hurdles. (TS/DC/JC)

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