Small Cap Value Report - Fri 27 April 2018 - talk at Mello Derby last night

Hello everyone! It's Paul here!

As promised, here are my notes from yesterday's talk about small caps at Mello Derby- opportunities & threats. (text follows below)

EDIT: Here is the video recording of my talk, which I hope people find interesting.

To start, I made this checklist, inspired by Mark Minervini. here it is again;

(Ideally, I want to see nearly all items below ticked, before even considering an investment)

PRIME SOAPED

PRODUCT - fulfilling an unmet need in customers. Desireable, with pricing power.

RECURRING revenues ideally, or at least not lumpy

INNOVATIVE company, which launches new products and services - ahead of the competition

MARGINS - should be high, giving operational gearing - big upside when sales rise. Must have some moat also.

ENTREPRENEURIAL management - preferably founders & still big shareholders

SCALEABLE - company must be capable of growing 5x or more (e.g. retail roll outs, cloud-based tech)

ORGANIC growth - strong, and preferably accelerating.(not by acquisitions)

ASSETS - balance sheet must be strong (NTAV)

PROFITABLE - or close to it

EARNINGS estimates - from brokers - should be rising, and repeatedly beaten by actual results

DIVIDENDS - nice to have, but not essential

Other things

Any DOUBTS about business model, management, or accounts, then don’t invest

(Main influence for above list is Mark Minervini - trade like a stock market wizard)

Hello everyone!

Thanks very much indeed to David, Georgina, and everyone else who has organised or participated in this event.

Mello is such a refreshing change from other shows, in that the quality of the companies presenting here is so much better than other investor shows. Also, David has filled the show with POSITIVE ENERGY- what a wonderful thing, and a refreshing change.

EDIT - please note that Mello welcomed the Stockopedia directory of summarised info about exhibitor companies. Why? Because people at Mello (investors and exhibitors) are intelligent enough to understand that the StockRanks system is just one way of looking at the market, which is proven to have a great track record overall, for a portfolio (not individual stocks).

Also, Mello attendees understand that a stock being classified as a "Sucker Stock" is just shorthand for a higher risk investment. I have a big personal holding in Sosandar (LON:SOS) - that is classified negatively on Stockopedia - which doesn't matter to me - because I've done my own research, and worked out that the future direction of the company is not reflected in the historic figures. Speculative companies tend to have lower scores on the Stockopedia system. Again, intelligent people ask, learn, and then understand this. Muppets just shoot from the hip, and make themselves look even bigger, deranged idiots than they looked beforehand!

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As I’ve mentioned before, my own investing journey has been quite a rollercoaster, with some wonderful profits, but also a complete wipe-out in 2008. This was caused by my making the mistake of having too much gearing, in illiquid stocks.

I’ve spoken about that extensively in the past, and as mentioned last night, I’m pleased to report that I’ve now settled all my old spread betting debts, on payment plans recently settled 5 years early.

I should say that Spreadex, who are here, have been absolutely wonderful in helping me find a solution to what was a massive problem. They are very good people, and provide an excellent service focused on small caps.

I’d like to make a few points about spread betting to start with.

If people do decide to use a spread betting account, I urge you to keep a very tight control over the gearing. You’re not obliged to use gearing either. A key lesson I learned (the hard way) is not to over-size positions in illiquid stocks. Otherwise you just can’t get out, if markets turn nasty.

Risk:Reward greatly deteriorates, the lower down the market cap range we invest. That’s not a problem if you’re buying a small quantity of shares. But as your portfolio gets larger, then you often find that buying say £100k+ of a micro cap share can end up being something you later regret, because you just can’t get out, especially if the company reports bad news.

So these days I’m trying to stick to companies over £50m market cap, and preferably over £100m market cap. Although I will buy shares in smaller companies, but usually scaling down the position size to say £20-30k if it’s something very illiquid.

For most people, I think gearing is best avoided, unless you’re experienced, and have the self-discipline to avoid getting sucked into speculative trades where you have no edge, such as forex or indices trading. It’s best to leave that sort of thing to people who know what they’re doing. It’s also incredibly stressful running those type of positions, I find. I’m much happier and more relaxed when I’m not doing that kind of punting.

If you do use spread bets, a useful way to avoid being sucked into speculative trades, is to ask Spreadex to disable online dealing. I’ve done that, and instead I have to phone my broker to place every trade. I use an intermediary broker called Patronus Partners, who then place the trades with Spreadex, often having secured an improved price. So it works very well, and stops me doing anything too stupid! The results have been pretty spectacular in the last 2 years, although we have been in a big bull market for small caps of course.

It’s easy to make money in bull markets. The hard bit is hanging on to that money when the market turns bearish!

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OK, Moving on to small caps stock picking.

I’ve been jotting down brief notes over the last few months, of interesting investing themes, and examples of companies where I’ve spotted something good or bad.

I’ve  separated these ideas into opportunities and threats.

Let’s start with opportunities. These are the things I specifically look out for, when reading the RNS every day, because quite often we can overlook things which are quite obvious in hindsight, and miss out on a good buying opportunity.

1. Expansion into new markets & new products - a simple way in which companies can accelerate their growth in earnings. A recent example is Topps Tiles. See SCVR 4 Apr 2018. The company plans to double the size of its addressable market, by branching out into commercial tiles (as well as retail). I’ve not bought yet, but it’s on my watch list. Somero Enterprises is another company which has been introducing new products and expanding internationally, with excellent results. I do hold SOM.

E-commerce companies are good examples - G4M, BooHoo, Asos, all expanding internationally - has triggered big re-ratings in the shares when international expansion starts to work.

2. Closure of loss-making subsidiaries - most stock market companies are groups, with various operating subsidiaries. So I look for groups which have a highly profitable core business, but loss-making peripheral operations. The beauty with this, is that the bad bits can be sold off, or closed down.

A great example of this a few years ago was Avesco - I was buying lots at around 120p. It had a fantastic US operation, but its other subsidiaries lost money. So the aggregate profit was quite low. The stock market then applied a low PER to the aggregate profits.

The big opportunity was that the company could sell its US operations for far more than the entire group market cap. Over a couple of years, it sold off or closed the loss-making bits, then having maximised profitability, management sold the group for 650p cash, a 125% premium. What a result!

The thing is, it was fairly obvious what the profit potential was. Other investors didn’t spot it because, the share was just off the radar, an obscure company that hardly anyone looked at.

A similar example now is Airea (AIEA) - it is closing a heavily loss-making carpets business, which will leave behind a beautifully profitable commercial flooring business, that’s making an operating profit of about 16% of turnover. I bought some shares in early 2017 at 33p. It’s recently paid a 6p special dividend, and announced a possible bid approach from James Halstead. I think the company could be worth up to 100p. It’s currently about 55p. The complicating factor is quite a large pension scheme (relative to the market cap), although this is now said to be fully funded. Worth a look. I hold. It’s very illiquid. If the bid approach comes to nothing, then the shares could drop, which would be a nice buying opp in my view.

3. Owners retiring - this was the case with Avesco. Googling can reveal if the major shareholder is at or above retirement age. With Avesco, Richard Murray & other Directors owned 33% of the group. It was clear that they were tidying it up for a sale.

French Connection - Stephen Marks (owns 42%) revealed recently that FCCN had been in talks for months, with a US company that approached it. Talks fell through. Tidying up the group by closing loss-making stores. Recently sold Toast for net proceeds of £13.9m. FCCN worth £48m, but now has c.£23m in net cash. Plus the debtor book for its wholesale customers. So business only worth its own working capital!

In end game for FCCN? No-brainer in my view. Takeout over 100p, maybe up to 200p, IMO.

Moving into profit this year, most bullish outlook comments in years.

Wholesale division profits up from £10m to £12.5m. Licensing £6.3m profit. Central costs £10m (could be reduced by an aquirer) and retailing losing £8.3m, but falling. Planning on reducing from 116 shops, to just 30. Average lease term only 2.9 years.

As close as you can get to a no-brainer, in my view.

4. Structural growth markets - any company that’s in a growing market.

Also I’m trying to avoid structural declining markets, e.g. newspapers, although Trinity Mirror is looking outstanding value again.

Good recent example is Clipper Logistics - its clients are growing fast, so it grows fast.

5. Sector re-ratings - at certain points, the market perception of particular companies can radically change. Good recent examples, have been BOO and G4M.

BOO warned on profits shortly after floating, and was only valued on a PER of 20 at one point. That didn’t make sense, when it has faster growth than Asos, which was valued on a PER of about 80 at the time. So there was a clear mismatch. BOO at 24p was an amazing opportunity. It more than 10-bagged, but has since fallen back to c.150p. Great results out this week. Management brimming with confidence. GDPR worries overblown - engaged & loyal customers, with only 13% churn. Instagram v important, email becoming less so.

G4M - similar situation - the market saw it as a low margin box-shifter. Yet the stellar growth (over 70%) it reported in late 2016 struck me as a great catalyst for a re-rating. So I bought as many as I could. I now have a photo of management inside my hallway, because that share paid for my flat! The key was spotting the opportunity for the share to radically re-rate, and then buying as many as I could get.

The flipside of this is that high growth companies will eventually de-rate from a PER of say 60 to something lower, usually about 30. A good example is JustEat, now on a fwd PER of 35. But it was a good bit higher, when the growth was faster.

Asos I think could de-rate, so I am shorting that at the moment.

6. Strong balance sheets - surprisingly few investors (even institutions) take much notice of the balance sheet. This provides a great opportunity. Companies with strong balance sheets are not only safer investments, and can survive a downturn in trade. But also the market often doesn’t price in the surplus cash. This allows companies to make acquisitions, which boost earnings, and push up the share price. Or you might get a nice special dividend. It’s often free upside, as well as downside protection.

A good example is Headlam (HEAD) - acquisitive, but lovely balance sheet. Cheap.

Numerous other examples, which I mention in my daily reports.

My 3 simple balance sheet tests;

• NTAV must be positive.

• Current ratio must be >1.3 usually, or over 1.0 for retailers.

• Net debt must be modest.

(examples of failure = Conviviality! Broke my own rules)

7. USA tax cuts - probably in price now, but not necessarily. SOM recently said that their tax rate will fall from 33% in 2016, to 21%. Great boost to earnings.

Threats

High operating margins - normally a sign of quality. However, attracts competition - e.g. Pat Butcher’s mob are now muscling in on SafeStyle, and its shares have taken a battering, with several profit warnings. WheelieDealer made the point on Twitter, that high margins are great, providing that is combined with an economic moat. Selling double-glazing has no particular moat, so SafeStyle’s high margins became a competitor’s target.

Micro cap illiquidity - liquidity is never there when you need it. I’m very reluctant to buy tiny market cap companies now. Risk:Reward can be terrible - as you can’t get out. When the market wobbled in Jan/Feb, I ditched some of my low conviction holdings. It took days to sell some of them. In 2008/9 liquidity dried up completely in many companies. So if you can’t sell, then make sure you

Prices are artifical for the smallest companies - the MMs quote prices, but often there is no meaningful size bid, or offered. Ignore the quoted bid/offer spread, as the real (unpublished) prices are nearly always inside the spread. In a bear market, you can often buy illiquid stuff below the bid price. This means having a proper broker, to “work” orders. I suggest having a proper broker for special trades, and using a cheap online broker for everything else.

When a big holder wants to sell, the stock has to be placed, often at below market price. E.g. Image Scan - who are here I believe - some stock was placed at 8p. Thought I was being clever buying some, as it was c.11p in the market. The price soon fell well below 8p.

Another example - years ago buying SpaceAndPeople in a secondary placing at 86p, whe shares were nearly 100p. Looked a bargain, but price soon collapsed & has never recovered. So a big seller often knows more than I do, and a discounted price can be a sign of trouble in the pipeline.

So, as there are often backed-up buyers or sellers, who cannot trade in a small stock, even if they want to, then the market price is artificial - it doesn’t represent true balance in demand/supply.

8. GDPR impact? Unknown at the moment, but could decimate email databases, as customers have to specifically opt-in. Could be a storm in a teacup? BooHoo said “What’s GDPR!?” Then when I explained, replied “we’re all over it. Not worried about it at all.” Customers are very engaged, not going to lose contact with them. Only 13% customer churn.

I’ve shorted Communisis & DotDigital - when I mentioned this at UKIS everyone burst out laughing. Why? My boss, Ed had just said Communisis was one of Stockopedia’s top5 shares for the next year!

9. Low interest rates - has caused over-investment, mis-allocation of capital. Asset bubble - people can borrow very cheaply for margin trades. Also too many restaurants, shopping malls, hotels, etc.  So over-capacity is a key theme that will I think become increasingly important. The single most important issue for retail/hospitality companies is, how long are your property leases? Short leases, means they can walk away from problem sites. CVAs likely to become very common - e.g. Carpetright, Mothercare, possibly Debenhams? The landlords will take massive pain in coming years, and rents have to come down a lot.

10. Permanent overhangs - small caps are not liquid markets. IT’s the small trades that set the price, but there can be backed up lack of liquidity, frustrated holders who really want out. So it’s worth looking at the Holding In Company RNSs, and seeing what the big shareholders are doing. A big overhang in Game Digital (GMD) was recently broken up & placed, with Miton taking a big slice at 35p. I think that’s bullish, as now most shares are held enthusiastically by new buyers not by stale holders who want out.

11. Dirctors comments / Outlook statements - look at the track record of each company. You have to be an optimist to be CEO of a small cap. But when reading updates, I like to look back at what companies have said previously. Do they serially over-promise & under-deliver? OR are they prudent, and out-perform. Obviously the latter is better.

Often with small caps, Directors don’t actually know what the future holds. E.g. Conviviality Directors spent c.£600k buying shares in the few months before insolvency. They had no idea the group was heading for disaster.

Is Director buying a good signal? Only if over £50-100k. Even then Directors are not necessarily good judges of their company’s value. But big buys, from Directors who are not seriously wealthy, is usually a good sign.

12. We like to think we understand companies, but in my experience, we really don’t know what’s going on. Our main source of information is the company itself. However, often things are going on behind the scenes which we’re not aware of. GlassDoor is a good source of gossip about companies. As David mentioned last night, talking to competitors & customers is interesting.

13. Being too cynical - causes missed opportunities. Some of my biggest profits have come from spotting an early turnaround in a company that everyone else thinks is terrible. So base decisions on facts, not pre-set opinions. Keep an open mind & be prepared to change your mind on a sixpence, if the facts suggest you should. Fortunes of companies change for better & worse, so if the facts change, we should change our mind. Chuck things out if the reason you invested has gone wrong.

14. Change of FD & accounting problems - recent examples - RBG - good business, cocked up their forecasts. Fell, then roseon bid approach. Bidders likely to be back. CVR - unravelled so fast. AIR - rebounded - no debt. So gives time to sort out problems.

15. IPOs - treat with caution. Several were bad businesses, which floated on back of buoyant, but unsustainable trading. Entu - high yield,looked great, went bust. Safestyle - shares have collapsed due to new competition. No moat. Anything to do with double glazing seems wobbly. Amazing how quickly the figures can deteriorate. UP Global Sourcing - buying things from China - price has collapsed. Where’s the moat? I dislike IPOs where founders are taking out money.

16. Retailing sector - under pressure, prices have dropped considerably. BUT, very selectively, there are opportunities. Key thing is short leases, and successfully transitioning online. The best is Next  - fwd PER of 12 - buybacks. Online now more profitable than shops. Can close entire stores network easily & at little cost. IT won’t come to that though, as rents reducing by 28%, concessions, and merging online/shops.

It’s very clear that Mello is where the higher quality companies come to meet serious investors.

P.