Stockwatch: This share stays on the 'buy' list

Is there further upside for £575 million, construction and fit-out group Morgan Sindall? After three years of trading in a volatile-sideways range of about 560p to 850p, the FTSE Small-cap stock has broken out dramatically this year - recently breaching 1,300p.

After brief profit-taking, the stock has regained this with an 80p leap after a 19 July, first-half 2017 update affirmed like-for-like trading "substantially ahead". Interim results due 8 August are expected to show about 45% pre-tax profit growth to £23.5 million.

While the table below suggests this is a modest first half relative to expectations for 2017 as a whole, see how £43.7 million was achieved last year i.e. a second-half profits bias.

Upgrades are starting to come through from the update's conclusion that "Taken together with the expected margin improvement in Construction & Infrastructure and the second-half weighting to Partnership Housing, the group now anticipates that its 2017 full-year results will be significantly ahead of its previous expectations." Consensus figures in the table reflect one upgrade, but at least another will follow - i.e. a 12-month forward price/earnings (PE) of about 12 times is set to reduce further.

Grasping the concept to "average up"

It's a classic challenge for stock-pickers, if hard for the value-conscious to grasp after a share price has substantially risen: should you "average up" where firms are beating expectations, even if the stock looks fairly valued?

Yet that's exactly what 20th century gurus like Jesse Livermore and Julian Robertson implored, rather than bottom-fish stocks liable to reveal (more) trouble. I consider both approaches have merits if applied judiciously: markets are prone to over-reaction and herd behaviour, thus recovery plays can emerge from bad news if dividends are secure and the company has strong market positions.

The likes of Burford Capital and Boohoo.com also show that multi-baggers can look fully-valued every time such companies declare strong progress; you won't find any margin of safety.

The crux issue in respect of Morgan Sindall is what mileage for the "UK infrastructure" theme I cited when making a case for the stock last May at 1,170p? Is it robust for the next few years, or might construction/refurbishment be exposed to any cyclical downturn? Does Morgan's latest update imply it is strengthening or the profits kicker imply near a peak?

Fit-Out remains the strongest driver

I noted in May how this division accounted for 45% of last year's profit: commercial offices representing 86% of its revenue, London being the largest geographic market at 65%. Thus, a key question is what future for London as an international capitalist city, or might Brexit undermine this to some degree?

There's also a sense how commercial property tends to be a late-cycle feature, with plenty of active development and refurbishment underway after eight years of steady upturn since the global financial crisis. Management says: "Forward visibility provided by the size and quality of its order book, indicate an out-turn for the year for Fit Out which is much stronger than previously expected."

To interpret that negatively would be to assume it results in over-capacity within London offices, especially if the Brexit commercial environment cools. More positively, sterling's devaluation raises the attractions of doing business from London, further to its time-zone advantages, and for overseas investment in commercial property. Based on evidence to date therefore, prospects are bullish and reasonably hedged.

Infrastructure spend becomes a political meme

The 19 July update also cites margin improvement within Construction & Infrastructure. Morgan prudently has a mix of private and public sector work: the split isn't quantified if hard to expect such a breakdown (for this size of listed company). Despite constraints on local government spending, since the general election "austerity" has become a dirty word with the Tories tending to distance themselves from it - to better-occupy the centre ground as momentum grows for Labour.

"Infrastructure investment" crops up increasingly as a declared aim to rebalance the economy from consumer spending, also achieve political capital by way of delivering improvements for people's daily life. For example, last January saw Morgan gain a share of Transport for London's £500 million surface transport framework, as one of three appointed contractors in the four-year project - involving the design and delivery of highways, tunnels, bridges and other structures on Transport for London's road network.

It's good to hear of margin improvement in this division, which represented 51% of 2016 revenue, albeit only 15% operating profit; by way of comparison partnership housing was 17% revenue, 21% profit; and urban regeneration 6% revenue, 21% profit. These other two divisions are in line with expectations, albeit with regeneration lower, like-for-like, due to phasing of completions - which seems more a timing than demand issue.

There's nothing as yet in the macro context to imply slowdown for these activities. Indeed, the UK political meme suggests a robust outlook for infrastructure, housing and urban regeneration - with Morgan Sindall a prime means of exposure.

Momentum stock if ultimately cyclical play

The dilemma with a broadly construction-related stock is that, unlike a genuine growth play carving out a new industry (e.g. international litigation finance, low-cost online fashion retailing), undoubtedly at some point a down-cycle will kick in. The bull case however is the Bank of England remaining overall reluctant to raise interest rates - and when they do, it will only be very gradual with governor Carney adamant a monetary stimulus should remain, to mitigate Brexit risks.

The private sector is, therefore, supported by low interest rates and the public sector by a shift in political priorities. Combined, this mitigates a potential worry about how Morgan's profits uplift as shown in the table could be exposed in longer-term context; that its cyclically-adjusted PE is much higher.

Momentum traders should, therefore, consider adding to holdings with the positive news story set to run well past interims due 8 August. Long-term investors, however, may note the dividend covered 2-3 times by prospective earnings, as if the board is wise to maintain strong cover lest the outlook softens.

More positively, there is scope to apply some of the group's £97 million net cash (as of end-June) for a special dividend or an acquisition, if sensibly priced. All-considered, therefore, risk remains on the upside and Morgan should stay on the 'buy' list for alert traders.