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Top broker thinks this outperforming stock is about to get a second re-rating

Shares in Downer EDI Limited (ASX: DOW) are tipped to continue outrunning the broader market in 2018 even as it delivered twice the return of the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) over the past year, according to Deutsche Bank.

The second burst of outperformance could come during the reporting season, in my opinion, which officially kicks off later this week.

The stock looks cheap compared to its peers even though the engineering and construction group is well placed to benefit from a pick-up in infrastructure spending and the increase in mining activity.

While the stock has performed well against the market, it is lagging its peers. You only need to look at Cimic Group Ltd (ASX: CIM) with its 40% gain over the past 12-months, along with the surge in the share prices of NRW Holdings Limited (ASX: NWH) and Emeco Holdings Limited (ASX: EHL) to see what I mean.

One reason for Downer lagging the sector is its acquisition of Spotless Group Holdings Ltd (ASX: SPO), which the market didn’t like, and its sluggish earnings growth momentum.

But things seem to be tracking better than what many had feared although the improved outlook isn’t quite factored into its current share price.

“To us this feels distinctly like the period between 2015 to mid-2016 when investors were concerned about Downer’s low earnings growth,” said Deutsche.

“However, from mid-2016 Downer received a [price-earnings] P/E re-rating and outperformed its peers, which we attribute to a catch-up to peer valuations and relative sector appeal compared to the broader market. For 2018 we expect Downer’s P/E multiple will again re-rate for the same reasons – catch-up to its peers and high valuations across the broader ASX.”

The stock is trading at a modest P/E multiple of 14 times, based on Deutsche’s forecasts. This compares to the 21 to 24 times multiple for most of its rivals.

Downer looks like a good bargain, especially given that the sector is looking fully valued and the broker sees a more than 20% upside to its current share price of $6.76 if you include dividends!

But Downer isn’t the only stock that is well placed to outperform in 2018. The experts at the Motley Fool are feeling particularly bullish about the prospects of one group of stocks.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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