Small Cap Value Report (22 Feb 2016) - Brexit, HOME, HDD, XPP

Good afternoon!

Up until today, I've been ignoring the Brexit issue - but as the politics seems to be hotting up (with Boris Johnson coming out in favour of Brexit today, and more senior Tories to follow no doubt), then it's worth thinking about the potential impact on our investments. That's an entirely different discussion from what is best for the country in the long run of course - where anyone who follows me on Twitter will already be in absolutely no doubt about my view on the matter!

The sharp fall in the pound today is actually rather helpful - making it more profitable for UK firms that export, but also of course meaning that imports get more expensive. A lot of companies blamed the strong pound for their profits being under pressure last year, so with that now reversing, it should now be providing a favourable tailwind for those companies.

I don't believe for one minute that the UK's trade with the rest of the EU would be very much affected if we do go through with Brexit. After all, we're a large net importer. So if the EU imposes a 5% tariff on all UK goods, and we do the same to them, then the UK will collect in far more tariff money than it pays out. That could then be recycled into an export subsidy administered through the VAT system, thus negating the impact of EU tariffs. Do we want to get into a trade war with the EU? Of course not, as it would just harm both sides.

So after an initial period where the EU tries to punish the UK for leaving, I believe that common sense, and self-interest on the part of EU exporters now finding it more difficult to access the UK market (or "treasure island", as the German car manufacturers call the UK) will return, and things will go back to pretty much how they were before - i.e. free trade.

Brexit really is not in any way a leap into the unknown. It's simply going back to being an independent, self-governing nation, like we have been for centuries, before 1975.

In any case, it's about getting back our democracy. If we have to give up say 3% of our GDP to become a self-governing, sovereign nation again, then frankly it's worth every penny.

You only have to look at Southern Europe to see that the EU is a disastrous experiment that has gone spectacularly wrong. It's corrupt, and undemocratic, and the sooner we're out, the better. Then we can do our own trade deals with the rest of the world, and really begin reconnecting properly with the English-speaking world, and powerhouse growth countries like India, setting our own agenda, not waiting in a side room whilst an unelected EU official that we've never heard of, thrashes out a deal that suits German exporters best.

Home Retail (LON:HOME)

I hope some readers managed to profit from the higher, competing bid for the Argos-Homebase (pending disposal) group. Steinhoff has indicated a potential 175p cash bid.

Personally I sold out gradually between 133-155p a little while ago, because my feeling was that risk:reward was no longer favourable, given that if the J Sainsbury (LON:SBRY) deal fell through, then the downside could easily be revisiting the sub-100p area.

I suppose the big question now is whether SBRY might try to sweeten their offer above 175p, or whether they will pull out? I don't see any recent statement from SBRY on the RNS, yet.

It just goes to show, the enormous value on HOME's balance sheet was tremendous hidden value, and it seemed obvious to me that, sooner or later, it would attract a bidder. Many people who looked at the share were not even aware that £800m of cash, and near-cash was sitting there in current assets - because they hadn't properly studied the balance sheet.

I feel that a failure to properly study the balance sheet is a glaring oversight in many investors. Just look at the tremendous upside on HOME which was lying there, dormant. It was a unique situation though - I've not seen any other retailer with so much hidden value in the balance sheet.

It's quiet for company results, but here goes with the ones that do look slightly of interest:

Hardide (LON:HDD)

Share price: 0.91p (down 4.2% today)
No. shares: 1,334.7m
Market cap: £12.1m

(at the time of writing, I hold a long position in this share)

AGM statement - this sounds rather negative to me;

"Hardide continues to make good progress in diversifying its customer base and thereby reducing reliance on a major customer and market sector. However, demand from the upstream oil & gas market is very subdued. The technical approval of the coating by Airbus, the recently-announced long-term supply contract for components for the revolutionary X-ray baggage scanner and other potentially high-value applications currently in test give the board confidence about the medium and long term prospects of the Company.

"The new US facility is fully operational and producing good quality coatings on customer parts for verification and life testing. Full-scale production is due to commence early in calendar Q2 2016. Additional employees have been hired to enable production levels of operation.

"The Board continues to monitor the oil & gas markets closely and is keeping the Company's cost base under tight control.

My opinion - when companies say that they are confident about the medium & long-term prospects, that is usually code for saying that things are going badly in the short term.

The comment about over-reliance on one customer, and the oil & gas sector, are also worrying. If I'd done my research properly, I would have found out about those points in advance, and not bought the shares.

However, this is a time to be humble, and admit my mistake here. I bought some shares in this company on impulse, after two positive-sounding announcements about new contract wins. I didn't do my research thoroughly enough, and hence missed the important potential negatives.

As a result, my impulse buy at 1.5p is now well underwater. What's worse still, is that I can't get out! The market makers are only offering firm prices on 50,000 shares at a time - that's only £455-worth! Anyone wanting to transact in larger size, will have to take a haircut. So my broker is currently ringing round, to see if any of the MMs want to buy some (or all) of my shares.

I have a horrible feeling that it will be a situation where I'll end up high & dry, unable to sell, and then the shares are likely to take a hit when results come out in May.

Ah, just had my broker on the phone, it's not quite as bad as I feared. Have had to take a haircut of just over 11% to get rid of them. So in my brief period of ownership, I had to over-pay to get in (as there were no sellers at the time), and now that things have deteriorated in terms of fundamentals, I've had to take an 11% haircut to get out! Given that the quoted spread is already wide, then this buy & sell transaction has been a bit of a disaster!

1.5p to get in, and 0.8p to get out. In just a few weeks of ownership. Dear oh dear, a very poor trade. This further reinforces my absolute revulsion for micro caps. Every time I cross the line into something this shockingly illiquid, it ends up being a disaster. So the lesson learned here is to do the research properly in the first place, and if it's an illiquid micro cap, the upside needs to be very much greater, to compensate for the difficulty in getting out.

Schoolboy errors. Putting it down in writing, for several thousand people to read, and tut at my stupidity, will hopefully make me think twice in future before making such a silly error again!

XP Power (LON:XPP)

Share price: 1521p (up 3.2% today)
No. shares: 19.0m
Market cap: £289.0m

Annual financial report - I am grateful to Colin, for pointing out in the comments section below that XPP has today announced its 2015 results. I missed it because the company really gave the wrong title to the RNS. Usually "Annual financial report" is only used to refer to the Annual Report being posted out, after the preliminary results have already been announced. For that reason I always ignore any announcement that is given this title.

XPP is an overseas company, but has a full UK listing. It has a long track record of being profitable, paying decent divis, so my usual reservations about overseas companies do not apply in this case.

The figures look alright, if unexciting. 9% revenue growth, to £109.7m. Adjusted profit before tax is up 6%, to £25.7m. Note the very strong profit margin, that's a 23.4% overall profit margin, which is superb.

Total dividends are 66p (up 8% on last year), so that's a decent 4.3% divi yield.

Balance sheet - looks good to me. Although inventories look rather high, at about 6-month's worth of cost of sales, so it could be carrying too much slow-moving stock perhaps?

Outlook - note the mention of macro headwinds, which a lot of companies are saying at the moment, which makes me nervous;

While we recognise a number of economic headwinds with the potential to impact our business in 2016 - notably slowing growth rates in China and North America -  we consider that we remain well positioned in our marketplace. We have good momentum as our design pipeline continues to grow, order intake in the fourth quarter of 2015 was strong at £30.0 million and we entered 2016 with a healthy order book.

In addition, following the acquisition of EMCO, we are excited by the prospects for our new high voltage DC-DC module product line, which will provide additional revenues this year. The combination of these factors gives us confidence that we should see further revenue growth in 2016.

We remain confident in the long term prospects for our Company.

So I read the above as saying that there could be trouble ahead, but things are fine in the short term.

Valuation - I'm not entirely sure if I'm comparing apples with apples here, but it looks as if XPP results for 2015 came in slightly ahead of broker forecast, after a wobbly Q3, but a better Q4.

Forecast for 2016 is 106p EPS, so at 1521p/share that is a PER of 14.3. That seems a reasonable price, if forecasts are achieved. The worry is the macro outlook which may lead to 2016 actual results being lower than forecast? Time will tell.

My opinion - I don't know enough about the business to form a view on it really. So I think it's a case of having to really get into the research in more depth, and understand the products, markets, etc.

The modest growth is a bit of a concern, and my worry is that such juicy profit margins might attract competitive threats. Nice divis though, sound finances, so if you think the company can maintain its margins, then it could be good. Overall, I'm probably neutral on this one, and would rather sit on the sidelines until it becomes clearer what the macro outlook is going to be like.