Small Cap Brokers: Bargain or Value Trap

When I created an earnings-based screen back in September 2022, I said:

It is notable that a number of investment banks would appear on this screen if they weren't excluded [by my chosen screen settings] and with very high TTM Earnings Yields.

However, I specifically excluded the Investment Banking & Investment Services industry group and, therefore, the small cap brokers since these require a different approach compared to analysing other trading businesses. This is because they have unique characteristics:

• They are very cyclical businesses whose performance is highly linked to stock market sentiment. The most lucrative part of their business is listing new companies on the stock market. These only happen when stock market conditions are particularly buoyant. So while the brokers may still generate fees from rescue placings in the depths of a bear market, these often only pay staff wages, leaving little profit for shareholders. For example, the 10-year EPS chart for Numis (LON:NUM) shows two periods where the EPS has dropped precipitously:

• As people businesses, they have weak moats. Often listed companies have a relationship with specific brokers, and if these leave a company, the clients often follow.

• They tend to hold significant cash balances, but this often represents regulatory capital and should be considered a fixed asset required for doing business, not a distributable reserve.

• There is little to no research coverage on these companies. It may seem strange, given that many of these companies extol the virtues of good research coverage to their clients. However, due to regulatory restrictions, they cannot write research on themselves, and they don't want to pay a competitor to produce a note. Hence they exist in a kind of research limbo.

The listed small cap brokers are, Cenkos Securities (LON:CNKS) finnCap (LON:FCAP) Numis (LON:NUM) Peel Hunt (LON:PEEL) and WH Ireland (LON:WHI) . Investors will undoubtedly be aware of these from their role as NOMADS or advisors to other listed companies. There are a number of unlisted competitors that investors may be familiar with, such as Zeus or Liberum. There are also much larger listed peers such as UK and South African listed Investec (LON:INVP) , or the big investment banks such as US-listed Goldman Sachs. However, these sharks rarely hunt in the same pond as the minnows.

So, if they have weak moats, why consider these companies as an investment? Primarily it is because the market is terrible at pricing these businesses. During the fallow periods, the market assumes that these companies will never be profitable again and prices them barely above tangible book value. In the boom periods, investors think these will carry on forever. Here is the share price chart of the small cap broker that has been listed the longest, Numis (LON:NUM) :

The share price for this company is even more volatile than the company's underlying business performance. Investors who can act countercyclical, buying when the stocks are hated and selling when they are loved, can generate exceptional returns.

Why invest now?

Given this volatility, the biggest question is, where are we in the stock market cycle for the smaller companies these brokers serve? While nobody knows for sure, the small cap investor is perhaps best suited to make this judgement. Because the small cap investor has their ear to the ground, they know when sentiment changes. My assessment of 2023 so far is that investor sentiment has been much more positive. Investors ended 2022 with large cash balances, mentally scarred by the significant falls in many small cap stocks. However, positive sentiment appears to have returned, and investors are deploying those cash balances. There are other signs that market sentiment may have turned, such as increased investor engagement with the Small Cap Value Report. In January, Monday's SCVR averaged 186 likes versus 148 for December and just 135 for November.

Yet, despite signs that the end market for small cap brokers is improving, share prices remain at or around their 52-week lows:

A basket approach?

Given the similarities between these companies, it may be tempting to take a basket approach and own all of them. However, while that may be a good approach, it is worth noting that the above stock price chart shows that while the overall trend is similar, finnCap (LON:FCAP) has dropped 61% over the last year versus just 31% for £NUM.

In addition to the differing share price performance, the companies have several fundamental differences. For example, WH Ireland (LON:WHI) has an asset management arm. Asset management firms tend to be more highly rated because the assets are sticky, and the company charges a management fee, not just a performance fee. finnCap (LON:FCAP) and Numis (LON:NUM) have significant Mergers and Acquisitions businesses that the others don't. The segmental reporting of each company is not an exact fit with each other. Still, the following chart gives a flavour of how each business is roughly split in terms of contribution to revenue:

Here are the pros and cons of each business:

Cenkos Securities (LON:CNKS)

Pros

Cenkos is the cheapest of the companies on a Price to Tangible Book value and a TTM EV/EBITDA basis:

This is due to their £23.9m cash balance being close to the current £26m market cap.

However, this appears to be based on the assumption that "Other financial assets" are cash-like:

However, these remain fairly consistent over time, so I see little reason for these being distributable assets, making the EV/EBITDA look too optimistic. Still, the dividend yield of around 9% is excellent if it is maintained. The interim dividend payout was slightly cut in October:

However, they also said:

The Board will continue to look to return significant value to shareholders while seeking to establish a level of consistency of dividend payments throughout variable market conditions.

This suggests they will try to maintain a reasonably-sized dividend even during periods of weak trading.

Cons

This is an illiquid stock, where the Exchange market Size is less than £1k in value and the quoted spread is over 10%. Investors may be able to trade in a larger size and buy within the spread. However, these costs will eat into any returns.

The biggest issue with Cenkos as an equity investment is how much of the return from exceptional trading periods goes to staff. As investors will be aware, 2020H2 was an exceptionally strong period for many small-cap brokers, as a strong recovery in equity markets post-COVID and the need for many companies to rebuild their balance sheets led to many equity raises. Cenkos' revenue in 2020H2 went up by £6.1m from the previous half, yet the staff costs increased by £5.8m in the same period. This pattern repeats each half-year since:

The returns from strong trading appear to always go to the staff and not shareholders, and there seems to be little chance of this changing anytime soon.

Conclusion

This company will attract investors who want a relatively stable dividend payout that won't rise and fall as much as the earnings throughout the cycle. However, fundamental questions remain over who precisely this company is run for as the returns to shareholders appear to always come second to the returns to the other company stakeholders, meaning that shareholders may not benefit from any recovery in trading in 2023.

finnCap (LON:FCAP)

Pros

Revenue has more than doubled since the company was listed in 2017. One of the company presentations shows the longer-term history of the company:

Over these 15 years, revenue has grown at a compound annual growth rate of 19%. Although some of that is via acquisition or other business combinations, this is still a very impressive rate. Conversely, over the same period, Numis grew revenue by a mere 4% compound.

The current company was formed by the merger of JM Finn with Cavendish Corporate Advisory and the listing of the combined entity in 2017. This means that the business is one of the most balanced ones, with M&A advisory revenue only just below that of the rest of the business in the last reported six months:

The company is committed to further growth in revenue and recently purchased a 50% stake in an ESG consultancy. They are unlikely to make wholesale acquisitions of other broking or M&A firms since they believe they have a unique culture within the industry of always doing the right thing for clients and other stakeholders, and wholesale acquisitions would dilute this. However, they would be willing to expand by adding the right teams of people at the right time.

In October and November last year, finnCap was in discussions about a potential takeover. The acquirer was unlisted Panmure Gordon. This may seem a little strange because, on measures such as turnover and profitability, finnCap is the larger business. However, Panmure is backed by some wealthy individuals, and at least part of the attraction would have been the easy way of listing. The sticking point seems to have been the price. The rumour is that Panmure was only willing to pay 20.6p. This perhaps seems a fair price based on measures such as Price-to-Tangible-Book, but it didn't include any premium to reflect the historical trend of rapid revenue growth. It can't have helped that both the Chairman and former CEO were buyers of the stock at 30.5p only about 18 months ago. I can see why neither side was willing to budge on this price, and the deal ultimately fell through.

Cons

finnCap is another illiquid stock because it is so tightly held. Over 66% of the shares are owned by current or former directors or management. The Price-to-Tangible-Book-Value is merely in line with the rest of its peers:

Up until last year, the CEO was Sam Smith, whose strategy was to ensure the company represented the very best of the industry. Many small cap shareholders appreciate that finnCap was one of the first to make their research publicly available. However, Ms Smith has left the CEO role to become a Non-Executive Director, and shareholders have yet to hear how new CEO John Farrugia will adapt the strategy.

It seems that the company may have suffered from a bit of hubris in 2021, expecting the strong market conditions to continue for a long time. They appear to have expanded their workforce too quickly in the boom times and have recently reduced their headcount. This has also left them with too much office space (although they were a victim of fate here as well, signing a new office lease shortly before COVID hit.) In my opinion, they overpaid for their stake in the ESG consultancy too.

The company may pay a dividend for the year ending 31st March, but this is not guaranteed and will depend on how trading pans out. They may choose to retain cash in the short term.

Conclusion

The company probably deserves its premium on measures such as Price-to-Tangible-Book-Value, given its superior track record of revenue growth. Their profitability is very volatile, not helped by an increase in costs that is now being partially reversed. However, when the company does well, this is reflected in EPS and dividends to shareholders. Their balanced model with M&A exposure means they are less exposed to the highly cyclical capital raisings and IPO market. The company's share price is the weakest of the listed small cap brokers over the last year. This probably reflects the illiquidity of the shares. However, if the market outlook is much more positive and this is reflected in positive earnings momentum, shareholders can expect this to bounce much more strongly than peers.

Numis (LON:NUM)

Pros

Numis is perhaps the most highly regarded of these smaller brokers, and they have successfully been winning larger clients. In addition, their research is very well received, showing that they are a quality outfit.

Their Price-to-Tangible-Book-Value is around average for the market but includes £100m of cash, giving them a very good EV/EBITDA rating (assuming that this period was a market nadir).

The cash balance means that the c6% dividend yield will likely be safe for the foreseeable future. Numis also have a significant M&A part of the business whose performance is less correlated with equity markets.

Cons

Although their research is of high quality, it is not available to individual shareholders. This perhaps represents an old-fashioned approach to equity markets and is reflected in their lacklustre revenue growth over the long term. This is a good company but a plodder, and In light of this, the company is never likely to be particularly highly rated.

In addition, trading has been a significant contributor to revenue in recent years, which increases the risk profile of their returns:

Peel Hunt (LON:PEEL)

Pros

Peel Hunt is another company whose research is very well regarded and is a new float (although they were previously listed from 1999-2004. The company seems more innovative than Numis and has recently launched its REX platform, which is:

…a platform owned and operated by Peel Hunt, to provide the service which further supports retail investors and the democratisation of capital markets.

Peel Hunt's valuation is very similar to that of Numis, again driven by a significant cash balance:

Cons

The company was an optimistic float at the end of a time of strong market conditions:

This means many stale bulls from the IPO may want to exit if the price rises anywhere near the IPO price again. However, this would represent a 100% premium to the current price.

Their fee generation was weak in the last six months, and their revenue generation relied heavily on corporate retainers:

However, they did manage to break even in this period and can expect to be highly profitable if the market for IPOs and fundraises is more supportive.

Conclusion

Peel Hunt is a well-regarded company. Although the valuation is merely in line with the sector, their innovative nature stands them in good stead. Their lack of M&A exposure means they are more exposed to cyclical markets. This is good if investors expect boom times to return. However, they also have a limited track record as a listed company, so we are yet to see how well they reward shareholders vs staff in these times.

WH Ireland (LON:WHI)

Pros

More than half of WH Ireland's revenue in the last reporting period comes from their wealth management arm (they don't break out their investment banking fees into retainers, fund raises etc.):

Wealth management is more stable than investment banking, and such businesses are often awarded higher multiples to reflect this.

The £6.3m cash balance is a significant proportion of the current £15m market cap. There are also £1.4m of warrants valued on Black-Scholes models and £1.7m of other investments. While the warrants have value, they may not be easily turned into cash and the other investments

The research that WH Ireland produces for clients is, on the whole, good work, and they make it available to individual investors, demonstrating a positive culture towards clients and shareholders.

Cons

The company has not grown revenue for many years and is rarely profitable:

Conclusion

Given a lack of growth and profitability over the long term, it is hard to see WH Ireland as an attractive investment unless they make significant changes to their business model. Something that they seem unwilling to do so far.

My thoughts

If investors believe that the current bullishness in small cap markets in 2023 is likely to remain, then it is difficult to believe that the small cap brokers won't trade well. In this case, the share prices will likely recover significantly, reflecting these increased profits. Investors who value dividends above all else may want to go for £CNKS. However, my pick of the bunch is £FCAP. It is not without risks and is working through the effect of some management changes. However, its long-term track record of growth stands out in the sector, as does its potential to bounce most strongly in response to good trading.

Second I would go for £PEEL. It is a larger, more liquid company and is highly exposed to any improvement in equity markets, missing the more stable M&A advisory business. This is not always a good thing, but at the current point in the cycle, it may make sense to maximise this exposure.

It is thought by many that the sector is ripe for corporate action itself. Because finnCap was subject to serious interest from Panmure Gordon but couldn't agree on a price, it may be amenable to other offers. Some form of a combination of Peel Hunt and finnCap makes sense to me. finnCap shareholders would gain scale and liquidity. Peel Hunt would gain access to the more stable M&A advisory business. Other privately-owned brokers may be interested in combining with any of these companies and gaining a listing. These are primarily people businesses, and as such, cultures and personalities don't always match, even if the logic of business combination makes sense. However, this is definitely a space to watch in 2023.

[Disclosure: Mark owns shares in finnCap (LON:FCAP) ]