Small Cap Value Report (27 Jun 2016) - FOXT, WTM

Good morning!

Well, what a shambles everything seems to be at the moment! Worse than that, Coldplay announced yesterday at Glastonbury that the country has collapsed. Perhaps a few more "Woah-oh-woahs!" are needed to straighten things out?

Markets hate uncertainty as we know, and it's difficult to think how there could be any more uncertainty right now. The market is doing what it is supposed to do - pricing in the risk of a downturn.

Results of an Institute of Directors survey, published this morning, reinforce my view that a downturn is now fairly likely. Not necessarily a deep recession, but some degree of economic downturn now looks inevitable in my view. Although prices in some sectors (e.g. housebuilders) are down so much, that any sign of things returning to normal could trigger an equally rapid rally, who knows?

Personally, I don't think the UK actually will leave the EU. The establishment are dead against it, and have indicated no intention to serve a S.50 notice until October, at the earliest. Even Brexit politicians seem to be rapidly back-tracking on things they said during the campaign. That gives time for the dust to settle, and a compromise deal to be thrashed out with the EU, on the quiet. Meanwhile, as the political & economic situation gets more chaotic over the summer, then I think some people might regret voting for Brexit - enough to tip the balance anyway.

This lays the ground for Cameron to triumphantly announce he has secured a decent compromise deal, and he can then hold a second referendum, which with younger people now galvanised into actually bothering to vote, would be won by Remain.

Pure speculation on my part, but that's how I see things panning out. If I'm right, then bombed out shares now could turn out to be bargains. If I'm wrong, and we do indeed have 4 years of chaos ahead of us, then many shares are probably still over-valued. Who knows? Each investor has to weigh up risk:reward, and make up your own mind.

In the long run though, things always get sorted out. Life carries on, and good businesses mop up market share from bad businesses, which fail in recessions. So if you take a long term view, then everything will be fine.

The other key thing is whether you think weaker sterling is likely to persist, or get weaker still? That affects the valuation of companies in various ways, and is an important point to consider for each holding you have.

Going back to the IoD survey, I noted down the key points, which said that;

• 2/3rds think Brexit will be bad for business
• 1/4 will pause recruitment plans
• 1/2 said won't affect their investment plans

So that gives a good idea of which sectors to avoid - capital goods, recruiters, and anything cyclical really. Having said that, those sectors have already been so smashed up in price, that a lot of bad news is already priced-in. So it all depends on the price, and how companies perform relative to expectations. Remember that you also get explosive rallies in bear markets, so panic selling is often done right at the low point, in my personal experience!

Osborne's speech

Yes, he's been found! I listened to Osborne's speech this morning just after 7am, designed to reassure markets. Key points that I noted down;

• UK economy fundamentally strong
• Banks safe - capital requirements now 10x what they were in 2008 crisis
• Deficit was 11% in last crisis, now 3% of GDP expected this year
• The people have spoken (re Brexit) and we must act on their wishes
• Economy will have to adjust
• Have well thought through contingency plans
• Won't be plain sailing, but financial system will help recovery, not hinder it as in 2008
• I intend to play active part in EU negotiations
• All Govt agencies working together, and consulting widely with other countries, and large companies

In my view the sub-text was to reassure that the grown-ups are in charge, and that he's on the case. Also, no mention of a "punishment Budget". Instead he said he'd wait for OBR forecasts to be updated by the autumn.

Foxtons (LON:FOXT)

Share price: 105p (down 22% today)
No. shares: 275.1m
Market cap: £288.9m

Trading update (profit warning) - the only surprise here, is that the market is surprised.

Current trading is not going well;

The run up to the EU referendum led to significant uncertainty across London residential markets and the decision to leave Europe is expected to prolong that uncertainty.  Whilst it is too early to accurately predict how the London property sales market will respond, the upturn we were expecting during the second half of this year is now unlikely to materialise.

As a result, the challenging conditions we referred to in our April 2016 trading update, which have impacted recent property sales volumes, are now likely to continue for at least the remainder of the year. We therefore expect full year 2016 Group revenues and Adjusted EBITDA¹ to be significantly lower than prior year.

When I last looked at Foxtons, its business was split about 50:50 between sales and lettings. So remember that the lettings business carries on as normal, even in downturns. I imagine that central London property prices could fall a lot, as it's been a crazy bubble of a market for years now. Whether that has much read-across to the rest of the country, is another matter.

H1 sounds far from disastrous;

2016 first half Group revenue is now expected to be slightly below prior year with a lower Adjusted EBITDA¹ margin in the region of 20% primarily due to subdued sales volumes and the costs associated with recent investment in our branch network.

Although the worry now, is how much worse will things get in H2, and next year? I really don't know how you go about valuing a share like this, in the current very uncertain situation?

Valuation - I'll take a stab at it! Last year's results showed revenue of £149.8m, and a 30.7% adj. EBITDA margin, giving £46.0m adj. EBITDA.

Therefore it we assume current year revenue down to say £140m, and a 20% EBITDA margin, then that suggests c.£28m EBITDA, down 39% on last year.

With a very uncertain outlook too, the current price of about 10x EBITDA really doesn't look good value.

My opinion - I think this company is impossible to value at the moment, as we don't know what's likely to happen with the London property market.

Punitive rates of Stamp Duty for higher value properties, introduced fairly recently, is another headwind. Furthermore, with sterling having fallen a lot, how will overseas owners or buyers view the plunging value of their London properties (measured in their domestic currency)? Will they dash for the exit, or see it as a buying opportunity? Outside the EU, London may be seen as becoming more of a safe haven?

Too many unknowns for me, so I'm giving this one a wide berth for the time being. Its balance sheet look OK though, so I don't see any danger of insolvency at the moment.

Waterman (LON:WTM)

Share price: 66.5p (down 18.4% today)
No. shares: 30.8m
Market cap: £20.5m

Contract wins - some positive news on 2 contract wins (although no financial details given). Unfortunately, the market doesn't care at the moment. Cyclical companies are being sold off aggressively, in anticipation of a slowdown in business in the future.

Although the outlook for Waterman was good, I suppose the market is now anticipating a slowdown, projects being put on hold, etc, due to Brexit.

This share does now look excellent value, based on existing forecast earnings & divis. However, we simply don't know how much we can now rely on forecasts. I think there must be quite a high likelihood that forecasts will need to be reduced.