Small Cap Value Report (28 Oct 2016) - ENTU

28th Oct '16 by Paul Scott

31 comments 16333 reads

Good morning!

It's very quiet for results today. I'm travelling back to Hove later this morning, so once back home will try to catch up on a few companies that I missed yesterday.

Bond yields

I don't follow bond markets in particular, because it strikes me that risk:reward on bonds could hardly be worse. You get no inflation protection (apart from index-linked gilts) on most bonds, yet the yield is derisory in most cases. So the risk is all to the downside (as the value of a bond will fall when inflation & interest rates rise), in return for a pathetic reward (yields are extremely low). Who in their right mind would want to buy that sort of asset? Pension funds seem to think they are matching their assets and liabilities by buying bonds, but what happens if there's a surge in inflation? Then a gap would open up. UK inflation is likely to rise to 3-5% in 2017, due to imports costing more after sterling's devaluation.

My Twitter feed is filling up with comments and articles about bond yields rising. It strikes me that this could be good news for UK companies which have significant pension deficits. These deficits have swollen in recent years due to very low bond yields - because the liabilities are measured with reference to bond yields. Liabilities increase when bond yields reduce, and vice versa.

So it occurs to me that pension deficits may benefit from rising bond yields. Mind you, presumably there would be an offsetting effect from higher inflation - meaning that the annual inflationary rise for pension payments would increase the liability. I'm not sure how the 2 factors would combine. Do we have any actuaries in the house, who could comment on the situation?

I hold over 40 positions in my family portfolios, and from memory can only think of one position that has a significant pension deficit (relative to market cap), which is Norcros (LON:NXR) (in which I hold a long position). I'm considering topping up there, as the valuation looks remarkably low - it's not often where you see the PER the same as the divi yield (both 5.2 in this case). Sure its pension fund is huge, but the overpayments are modest. So instead of seeing a huge liability, I see a manageable cash outflow for maybe the next 20-30 years. It hasn't prevented the company…

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daveinthelakes

28th Oct '16

I am no expert but surely when interest rates rise the value of many of the bonds currently held by pension funds fall?
I believe it is a widely held view that bonds were a one way winning bet with falling rates and quantitative easing but presumably the reverse is true with rising rates?

RNS at 1:55pm Luke Johnson has built a 10%+ stake in Elegant Hotels.

TIBARRETT07

Paul, I have recently bought into Trinity Mirror for the reasons you suggest, plus that from the late 90's onwards many pension schemes introduced a cap on annual increases; ie lower of RPI / CPI or 2.5%. Althought this only applied to future accruals, high inflation will reduce the real cost of pensions / pension liabilities. Surely there is no bigger bet on this strategy than Trinity Mirror!

gus 1065

Presumably that is the other side of the trade that saw Vision Capital take their holding down from 22% to 12% as per the RNS this morning. Nice and neat way of selling a large stake without bombing the price out.

Gus.

Trident

I suspect the circumstances of most pension funds will be pretty variable, depending on their make-up, size etc. On a defined contribution scheme that has been closed to new entrants, maybe if interest rates go up, perhaps there will be decreasing strain on contributions required by companies.

However, the complexity of pension schemes make-up, plus the regulatory requirements to make Minimum Funding Requirements reviews every three years, may make the outcome less predictable than merely just assuming because interest rates have gone up there will be a quick across- the-board drop in contribution levels required by most pension-bound companies.

weissdl

BONDS - I tend to think of Corporate bonds which I think should be part of a balanced portfolio. I aim to buy bonds on issue & current returns are 6/6.5% with bonds now trrading @ above face value - better than holding cash IMO

Wimbledonsprinter

I agree shipoffrogs. Triennual valuations usually throw up upward revisions to liability estimates - I would look at the longevity assumptions disclosed in the annual report of any pension deficit company - do they look reasonable - or are they likely to rise again in the next triennual review. Remember that most companies would love to get rid of their defined benefit liabilities - why don't they - the insurers (eg PIC, JRP who offer to "buy-out the fund") are quoting a valuation of the liability generally significantly in excess of how the company is valuing it. In reality companies are mostly not prepared to bite the bullet and so keep playing the long game.

Rambridge offers a good screen - other companies that may be worth looking at are Communisis (LON:CMS) (div yield> P/E), Carclo (LON:CAR) (recently had to cancel an already declared div, because of an increase in pension deficit and more recently did an equity raise, partly to fund a small acquisition), £ TNI.

Also remember while Philip Green may not be on the front pages - any parliamentary investigation into BHS is more likely to lead to greater security being given to pension beneficiaries.

Jack Brumby

It's potentially very interesting -- never been to Barbados myself (sadly), but Risk Capital have had some big wins over the years and Leisure is the sector they tend to specialise in.

I had a quick check and EHG seems to be on a 9% dividend yield (if it sticks by its 7p per share guidance) and has come off the boil since its IPO, from 100p to 75p.

Would love to hear anyone else's thoughts on the development; will try to free up some time at the weekend to do a bit more digging. Gus 1065 looks to be right re. Vision -- can't say I've come across them before.

TMFMayn

I hold over 40 positions in my family portfolios, and from memory can only think of one position that has a significant pension deficit (relative to market cap), which is Norcros (LON:NXR) (in which I hold a long position). I'm considering topping up there, as the valuation looks remarkably low - it's not often where you see the PER the same as the divi yield (both 5.2 in this case). Sure its pension fund is huge, but the overpayments are modest. So instead of seeing a huge liability, I see a manageable cash outflow for maybe the next 20-30 years. It hasn't prevented the company from paying generous divis, nor making several decent acquisitions, so why is it such a big deal to investors? I think the fears are overdone, presenting a nice value opportunity perhaps.

I reckon the remarkably low PER is because the overpayments are far too modest, and more needs to be pumped into NXR’s scheme.

Rather than speculate about a pension scheme’s future liabilities and what assumptions underpin their calculations, another way of evaluating a scheme is to simply take the plan’s assets and compare them with: i) the contributions made by the employer and employees; and ii) the annual benefits paid to the scheme’s members.

Shareholders can then assess whether the assets and contributions look sufficient enough to produce the required benefits every year.

It’s a bit like assessing your own retirement plans…i.e. I have X in my pot, I need Y to live on every year, and so I need Z% a year from my pot to make ends meet.

For NXR, its pension scheme had year-end assets of GBP 365.9m, while contributions were £2.1m and benefits paid were £24.1m.

So you could say the plan needs 6.6% a year to cover its benefits payments without contributions (24.1/365.9)… or 6.0% if you factor in the contributions ((24.1-2.1)/365.9).

So, 6% a year — sounds easy enough for us smart stock-pickers :-), although as we all know if the fund has a bad year then the required Z% return soon ratchets higher. Benefit payments from pension funds just can’t be deferred as you can with withdrawals from your own portfolio.

Anyway, how does NXR’s required 6% compare to other quoted companies with pension funds?

I have taken the other 18 names from the list Ramridge provided above, to arrive at some idea of relative funding from a decent mix of companies. Here are the required returns in descending order (the negative figure for TSCO is due to its contributions exceeding the scheme benefits paid):

RNO - 7.0%?
NXR - 6.0%?
CAR - 5.2%
?CFYN - 4.5%
?DVO - 4.3%?
GKN - 3.4%
?TATE - 2.8% ?
BT - 2.7%
?GNC - 2.1%?
MNZS - 1.6%?
MGAM - 1.4%?
MACF - 1.3% ?
BAE - 1.2%?
WTB - 1.1%?
MCB - 1.1%?
SYNT - 0.8%
?BRAM - 0.2%
?TCG - 0.0%
?TSCO - (3.1%)??

From this small study, I would say NXR’s contributions are far too modest and more needs to be pumped into the scheme on an annual basis. It is notable perhaps that of the top three, RNO does not pay dividends at present and CAR recently suspended its dividend due to pension accounting technicalities.

I calculate NXR’s contributions would have to rise from £2.1m to £9.5m a year to lower the required plan return down to 4% (assuming benefits stay at £24m a year) and come closer to matching the funding efforts of this sample. ?

Aislabie

It is interesting that Wincanton (WIN) does not make the Pension Deficit list. It may be that with negative net worth the calculation becomes confused.
Although it has taken tremendous strides in reducing it,the pension deficit remains substantial. With the stock report showing 98% gearing after including the pension and that £184 million of negative book value WIN usually makes these lists

jjis

On Pensions, Bond Yields & Norcros. In the short term not sure the reversal of bond yields will help that much as it is only unwinding the falls seem since about May / June this year and against that Inflation is expected to rise in the short term too. From Note 23 of Norcros R & and the sensitivities it seems that longevity risk is bigger and that interest rate / inflation moves may just about offset each other whereas a 1 year rise or fall in life expectancy has about twice as much impact. Worth noting that NXR's is quite a mature scheme with 61% of members pensioners and the weighted obligation therefore around 16 years.

Ramridge

Hi Aislabie - Yes, you are right. I filtered out negative Gearings thinking that it effectively means that the co. is cash positive. But actually you can have a negative Gearing by the numerator being positive , i.e. net debt, and denominator being -ve, i.e. a negative asset value, as is the case with WIN.

You can see that by looking at the StockReport in the Other Ratios box. By using this data, the Ratio (per my tabulation) becomes, (-78.7/ -21.4 = ) 3.7 . It definitely qualifies for the rogues gallery.

Mark Carter

"Pension funds seem to think they are matching their assets and liabilities by buying bonds"

I think the logic is that it's "risk free", but as Howard Marks notes, nothing creates more risk than the notion that something is risk-free. Basically, pension funds are behaving utterly mindlessly. They're supposedly professionals. All this is sure to end in tears.

A year or so ago, when compulsory enrollment of pensions was being introduced, I was automatically signed up for a pension. Of course, it was for something that invested in bonds. Anyway, I scrubbed it, realising what a waste of time it was.

In June 2016, the FT reported that the 10-year gilt yield fell below 1%.

According to Stockopedia, Unilever offers a dividend yield of 3.3%. Br Amer Tobacco offers a yield near 3.9%. These are big, safe, companies that offer a superior return and will likely be a hedge against inflation.

What leads us to this utter insanity? It's the thinking that stocks are somehow "risky", and gilts are "risk free".

Another scandal in the making, and all the talking heads will be wondering how they got themselves into this mess, and what regulations should be put in place to ensure it doesn't happen again.

Rant over.

iiimurray

Paul
Don't profess to understand the legal complications requiring pension fund shortfalls to be given preference over dividends in relation to distributable surplus in trading accounts but if Carclo were 'forced' to withhold announced dividend (poor management) then why does this not apply also to all other companies including Norcros as identified on the Stockopedia list? Surely it is now imperative that the legal restrictions being applied should be amended as this shortfall is entirely a short-term consequence of low interest rates and becomes relatively insignificant when looking at the long-term obligations of pension funds.

Dale

What TMFMayn’s method shows is that the Norcros pension scheme is more mature than all the other schemes (except Renold).

The Norcros pension payroll is close to its peak (there are various semi-public sources which verify this), and will decline from here. This is baked into the demographics of the scheme (which is closed to future accrual).

It therefore isn’t true to say that Norcros fund “needs” 6%pa per annum if no contributions were made.

That statement would be true if the pensions needed to be paid in perpetuity. But they don’t – they only need to be paid for the remaining lifetimes of the membership.

In other words: the pensions will be paid from a mix of interest and principal.This isn't a problem, it's the plan!

And if the plan works exactly (which of course it never does), the fund reaches zero on the day the last pensioner dies.

Deegee Eff

Can anyone tell me whether in the event of deflation pension payments would be reduced ? I know in the one period it did happen a few years ago mine wasnt, but times are different now and presumably they would be entitled to ?

xcity

Will depend on the terms of the pension scheme.
Most, I suspect, don't have terms that allow reductions if there is deflation, just rises with inflation.

kenobi

29th Oct '16

yes indeed that would be my observation, low yields may be bad, but it means capital increases, when this reverses won't it create a massive whole in the capital value ? I wonder what % of pension funds is in bonds rather than shares ?

K

DGBell

Big post from Paul today on G4M on the Adfvn board,well worth reading.

30th Oct '16

Hello Dale

Thanks for the comment.

You can't really conclude that NXR's pension scheme is more mature simply from my method.

To determine whether it really is more mature, you would actually have to compare NXR's scheme -- average age of member, etc -- with those of the other 18 companies.

You never know, maybe some of those other 18 companies also have mature schemes -- and yet they are currently paying much more relatively into their schemes than NXR is paying into its scheme.

Overall, it would be useful for NXR shareholders to demonstrate that the NXR scheme really is more mature than those of other companies -- and so justify NXR's apparently low level of contributions -- rather than just rely on management claims in a results presentation.

Well, that is exactly the same situation for all the other 18 pension schemes on that list.

And yet all but RNO have greater assets/contributions in relation to benefits currently being paid.

Small Cap Value Report (28 Oct 2016) - ENTU

Bond yields

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Paul Scott

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