Small Cap Value Report (3 Nov 2016) - VCP, IGR, GBG

Good morning!

Exchange rates

I've been pondering this issue a lot lately. On balance, I'm beginning to wonder whether myself & other commentators might be over-reacting a little? Certainly prices of most things will rise, due to weaker sterling. However, I was reading an article yesterday saying that a lot of larger retailers have hedged their currency forward by a considerable amount - e.g. Debenhams is 1-2 years hedged apparently. So maybe inflation could be more gentle & gradual than I previously thought?

Also, if you look at the long term chart of sterling against the dollar, we saw a huge devaluation from mid 2008. Sterling dropped from about $2.00 to a low of around $1.40. That caused a surge in inflation for a while, before it came back down again. It's no wonder that the British manufacturing sector was hollowed out, with sterling having been overvalued for so long.

A burst of inflation could be seen as a good thing, as it will scrub off some of the national debt, and private sector debt.

I think smaller retailers will feel the pain most, as their larger competitors will be cushioned from the impact of higher prices through their currency hedging. Also the bigger companies have more leverage to resist price rises from suppliers.

Breaking news! The Government has apparently just lost a court case over invoking Article 50. This apparently could delay Brexit, which has given sterling a boost - it's bounced a little in recent days to about $1.24.

Victoria (LON:VCP)

I had a fascinating meeting yesterday with Geoff Wilding, the former investment banker who has been instrumental in Victoria Carpet's remarkable renaissance over the last 4 years. He gave me a masterclass in how to do a successful buy & build (he's done 6 of them, in various sectors, including Victoria, so is worth listening to).

His 4 key points were;

1) Don't buy turnaround situations. Target companies must already be well run, and profitable.

2) Retain existing management - lock them in with earn outs over 3-4 years, to keep them motivated & involved.

3) Buy companies which have modern factories & equipment - this minimises capex requirements in future.

4) Management have to be honest & trustworthy. If in any doubt, walk away.

He pointed out that many private companies have very inefficient balance sheets, as owners often focus on profitability, but not ROCE. So there can often be surplus assets on the balance sheet, which is great for an acquirer - cashflow can be freed up from squeezing inventories & debtors, selling freeholds, etc.

Carpet-making is quite simple, and should generate good cashflow, if company is well managed. So quality of management is the critical success factor - "any idiot can run a tufting machine, but not everyone will make money from it!" The machines are big, but only cost about £400k each. So you can generate a lot of revenue & profit from relatively modest capex. The good cashflow is one of the reasons why Warren Buffett bought a large carpet manufacturer.

I really like this company, but aired my concern about its debt, and relatively weak balance sheet, and what impact this might have in an economic downturn. He showed me a graph which depicted the cost structure, and most costs are variable, or semi-variable. Therefore, carpet-making has little operational gearing - so profits should be fairly safe, even in a recession, as most costs would reduce (perhaps after a delay) in line with reduced revenues.

He doesn't sound at all worried about debt - saying the business has scope to increase its borrowings if the right deal came along. If debt ever did become a problem, he would just switch off acquisitions for a while, and the strong cashflows would repay debt fairly quickly.

By the end of the meeting I was regretting having recently sold my VCP shares! I only sold them as part of a general portfolio pruning, due to margin calls after a few other things had gone wrong. It's certainly back on my buying list, but I'll bide my time until after the US Presidential Election is out of the way - as that seems to be causing some general market turbulence at the moment.

I wish there were more hours in the day, as I'd like to meet more management - you learn so much from discussing the business with its CEO. Good news also - as I was impressed with the company, I invited Geoff Wilding to do an audio interview with me for Quality Small Caps after the next set of results, due out later this month. He said yes, so I'm looking forward to doing that, and will soon be soliciting your questions for me to ask him.

Geoff Wilding is an engaging, and interesting New Zealander - and pretty direct - so you get straight answers to questions. It amused me that a couple of times he paused mid-sentence, frowned, then said, "No, I can't say what I was about to say, I'll get myself into trouble!"

IG Design (LON:IGR)

I see this share has fallen a lot recently. A month ago the share peaked at 309p, but has since dropped to 240p, on no news. So I've been looking again at the share, to see if it's worth buying back into - I sold mine at 280p after it shot up after being tipped in a magazine, as it looked fully, or even over-valued to me.

On revisiting the numbers at 240p per share, I can't say that it looks cheap. Given that there's a fair bit of debt, the forward PER is over 15, and the dividend yield is only about 1.5%. Hardly a bargain, even after the big recent fall.

This is the problem with a lot of small caps right now - many things have risen unrealistically high on momentum, leaving the fundamentals looking stretched.

GB (LON:GBG)

This is another share which has looked very expensive for a while.

The share peaked at c.350p in September, but has fallen sharply to 239p now, despite an in line trading update on 20 October. The downside could be explained by the change in CEO, although that was announced a week earlier, and didn't move the price much.

The only downside I can see is that a UK Government contract is proceeding more slowly than anticipated.

So having scrubbed off all of this year's share price gains in just a few days, is this share now good value? Not really, no. It's still rated at 22 times forward earnings, and a paltry 1% dividend yield (although people don't buy growth companies for the yield).

So this is perhaps another example of an overvalued company correcting somewhat in price? It's nowhere near bargain territory though, despite the big sell-off. That's the problem with growth companies at the moment - they're far too expensive in many cases, leaving no room for any disappointments.

There are loads more trading updates out today, but I didn't get round to reporting on them. See tomorrow's report for a catch up on the backlog.

Regards, Paul.

(usual disclaimers apply)