Small Cap Value Report (28 Jun 2016) - ITQ, NFC, SEPU, UNG, ANP, HMLH, CPR, FJET, CBUY, CHRT

Good morning!

Looks like we might get a bit of respite today, as the Futures are up overnight. What a terrible day yesterday - one of the worst I can remember in my c.20 years active investing. My portfolio took an absolute battering.

So what's going on? Well clearly it's more than just the immediate impact of the Brexit vote. The market is now actively pricing-in an economic downturn. This normally happens over months, at the end of the economic cycle. However, this time it seems to have happened in 2 days (or more, who knows?) - due to the catalyst of the (unexpected) Brexit vote.

It's been carnage for shares in housebuilders, banks, recruiters, real estate, retailers, and some other sectors. Plus we saw random, panic selling yesterday too.

Just to clarify, I'm not interested in the politics of Brexit in these reports per se. We've had the Referendum, and I accept the outcome. My only interest here is to try and work out what happens next, and how it's likely to affect the economy, and therefore share prices.

As investors, the whole concept of what we're doing is trying to predict the future. We buy shares that we think will be future stars (and hence go up in value). We sell shares if we think they're likely to go down. Different people have different timeframes & methods for this process. Essentially though, the concept of investing is all about trying to predict the future.

You can't do that without taking a view on the likely consequences of Brexit. You don't have to agree with my opinions, and I welcome a sensible debate in the comments section - but please no more endless repetition of all the pros & cons. We've done that to death already. Let's try to keep the discussion to what happens next, and how that might affect shares, sectors, etc.

Economic downturn?

It's looking increasing likely that we're now going into an economic downturn. Whether that turns into a recession (2 or more quarters of economic contraction), I don't know. At the moment, my thinking is that it's probably likely to be a fairly mild downturn, because interest rates are likely to remain at rock bottom. Also, the banks are now relatively well capitalised, so I don't currently see a risk of another credit crunch. As above, form your own view, this is just mine, and is subject to change of course, as the facts change.

Recruiters

The canaries in the mine? Prime People (LON:PRP) reported terrific figures last week, but cautioned about the outlook for the full year. Then yesterday we saw a savage market reaction to a profit warning from Interquest (LON:ITQ) - shares down 45% to 45p on a statement saying that net fee income and EBIT for calendar 2016,

...will be materially below market expectations.

The share price has now dropped by 2/3rds since it peaked in Oct 2014.

I've been looking through the recruitment sector, and it's been carnage. Most have experienced huge falls. So the question is now whether the downside is fully priced-in, or whether there is more bad news to come?

It seems obvious to me that there are likely to be loads of profit warnings from this sector in H2 this year. After all, when economic circumstances turn uncertain, the first thing companies do is to pause hiring new staff (although there will still be the need to replace key staff who leave or retire).

I was thinking about adding more Matchtech (LON:MTEC) but have changed my mind now. It's already halved, so the selling opportunity has gone there. So personally I'm intending to just ride out what is likely to be a bad year. Things will pick up in due course, if you take a long term view. If you're not prepared to risk a sharp fall in price, then obviously selling is the way to go.

Earnings & dividend forecasts

I did a video on Saturday, screening for possible Brexit bargains, but it backfired rather, because I didn't take into account that the market was busy aggressively de-rating cyclical sectors.

This got me thinking, that to a large extent I think we need to now ignore broker forecasts for both earnings and divis. If, as seems likely, the economy is likely to slowdown, then earnings forecasts will almost certainly be too optimistic currently. So to base investing decisions on overly optimistic forecasts, would be a considerable mistake.

What people forget is the impact of operational gearing. In some sectors, a 10% fall in turnover can cause a 50% fall in profits. Companies then have to cut costs, which involves restructuring charges, etc. So suddenly your apparent bargain on a PER of 7 is actually on a PER of 14.

Balance sheets

This is the time when my discipline about balance sheets should really come into its own. There's nothing in my portfolio which would need to raise cash in a downturn, which should protect the downside somewhat.

When looking at bank debt, check the covenants, and see if the company would breach them if profits say halved. The key covenant is usually Net Debt : EBITDA. If that's more than 2.5 times, on reduced profit expectations, then there could be trouble ahead.

So I think getting out of heavily geared cyclical companies now is possibly a very good idea.

Profit warnings

Expect lots of them in the coming 6 months, basically. The other thing is that companies may report good figures, but the outlook comments are more important. If business is slowing down (as it is likely to in some sectors), then you have to value the share on future profits, not (higher) historic profits.

Having said all that, when we buy shares, we're buying the company's earnings in perpetuity. Therefore we should accept that the PER will go up in bad years (because profit has fallen). However, investors will sooner or later begin to anticipate economic recovery. It's probably too soon for that though at the moment - we're only just starting the downturn.

Sterling

I see weaker sterling as a good thing, in that it makes the UK more competitive. Remember the 1930s, when countries competitively devalued, to gain competitive advantage?

What better antidote to the uncertainty over Brexit? People are worrying over inward investment into the UK drying up, but personally I'm more sanguine about this. The UK just got considerably more competitive, thanks to the steep fall in sterling. Combine that with our flexible labour market, ease of starting up businesses, good legal & accounting frameworks, lack of public sector corruption (so you don't have to bribe the mayor to open a restaurant, for example), and that English (the world's second language) is widely spoken here (although often not very well - many vox pops of Brits on TV need subtitles I feel!), and this country is still an attractive place for overseas companies to make acquisitions, or set up factories.

Weaker sterling is also going to stimulate inbound tourism. It enables domestic producers to undercut more expensive imports, and of course will stimulate UK exporters.

On the downside, weaker sterling will make imported goods more expensive, thus increasing inflation (from nil though, so shouldn't be a major problem).

One way or another, UK producers will still export into the EU. Worst case scenario, they have to pay the common external tariff, of 3-4%. That's already been roughly offset by the fall in sterling. So personally I think the market might realise after a while that things probably won't be as bad as some currently fear.

The passporting issue for services is probably my main worry at the moment. I fear that there could be an exodus of companies to Frankfurt or Paris, but let's hope not.

Given the above, I feel there are good opportunities to be had for shares in UK companies which export most of their production (e.g. Zytronic (LON:ZYT) which I hold), and also UK companies which generate most of their earnings in US dollars. A good example of that is Avesco (LON:AVS) (which I also hold) - which makes more than 100% of its profits from its US division, called CT USA.

4imprint (LON:FOUR) (I don't hold) makes its profits mainly in the USA, as of course does Somero Enterprises Inc (LON:SOM) (I do hold). So this is a good area to hunt for bargains I think - investors just dump things in a panic, sometimes without thinking that current events are positive for that share. This is the main reason the FTSE 100 has held up so well - as c.70% of its earnings are in US dollars.

Health

This is an incredibly stressful time, and I'm sure many readers are under great stress at the moment, as indeed am I. Health comes first. It's vital to switch off the computer from time to time, go outside for some fresh air, breath deeply, do some exercise or gardening, or read a book, or listen to some music.

I felt terrible last night, so switched off the computer and went for a jog along the seafront here in Hove. It made a tremendous difference, eradicating the stress, and clearing my mind into a much more clear-thinking state.

So I do hope that readers look after your own physical & mental health in these stressful times for us & our country.

Also, a bit of positivity goes a long way. I'm tired of politicians & commentators running down this country. It's a fantastic place to live, and we're lucky to be here. A small minority sometimes ruin things - like the ghastly racists attacking immigrants. These are relatively isolated incidents, and in no way representative of our country, nor in fairness the vast majority of people who voted Brexit, who I think mostly did so for the right reasons.

One way or another, Britain will get through these problems. 

Right, on to today's news. Only shortish comments today, as there are loads of companies reporting, and I have a 2 hour drive to an investor lunch at noon.

Oh, and the above are just my opinions! Some will be right, and some wrong. It's fine to disagree, and discuss.

Next Fifteen Communications (LON:NFC)

Share price: 233p
No. shares: 72.2m
Market cap: £168.2m

AGM trading update - this statement perfectly illustrates some of my points above! A happy coincidence that it's the first company here. This is a digital marketing/PR group, from what I can gather. It has an unusual 31 Jan year end.

Trading seems to be going well;

Next 15 is pleased to report that the good start to the new financial year has extended to the first four months of the period. Driven by strong organic revenue growth from our North American businesses, the period has also seen continued revenue growth and margin improvements in the UK and Asia as the Group’s work to simplify its non-US operations progresses. Next 15 has also seen an improvement in its business in EMEA.

Sounds good across the board.

3 acquisitions are performing well.

Comments on currency;

The Board notes the recent volatility in the value of the British pound, Next 15's reporting currency, following the result of the UK referendum on membership of the EU. With approximately 75 per cent of the Group’s revenues generated in other currencies (and in particular 60 per cent deriving from the US), the Group’s reported results stand to benefit on translation from a weaker British pound whilst the impact on the Group of any slowdown in economic activity in the UK and EU should be relatively modest.

How interesting! This is a great example then of finding a share which is not just immune from sterling weakness, but which may actually benefit.

My opinion - it looks quite good. Nicely ring-fenced from current UK problems.

I covered the last interim results in some depth here on 13 Oct 2015. So have a recap on that report, if you want my comments on the balance sheet (a bit weak), etc.

One to put on the watch list, I think.

Sepura (LON:SEPU)

Share price: 44p (down 18.5% today)
No. shares: 185.2m existing + 185.7m new = 370.9m after fundraising
Market cap: £163.2m after fundraising

This is one where I warned readers about the likelihood of a discounted Placing, after a profit warning a few months ago. The longer it takes for a deal to get done, the more brutal the discount, usually. It's truly awful - a Placing & Open Offer at just 35p.

It's fully underwritten, so the fees are high at £4.4m on a £65m fundraising. I am delighted that the company has done the right thing, and included an Open Offer for existing shareholders. This is vital where a deep discount is involved, as the legal principle of pre-emption rights should at least partially be respected. So well done to Liberum and the company itself for doing the right thing by including an Open Offer too - it's 1 new share of every 3 existing shares held.

This share was 200p just 3 months ago, so it's been a disastrous case of shareholder value destruction. This is because the company had a stretched balance sheet, with too much debt, and then ran into trading problems. So the bank must have insisted on an equity fundraising, which they had to do on terrible terms.

Yet another example of the danger of being reckless with bank debt. This is exactly why I place so much emphasis on balance sheet strength. Had the company been debt-free, the shares might have halved on bad news, but would have then recovered over time.

It's a pity, because the figures for y/e 1 Apr 2016 are not actually that bad. It's just that they borrowed too much from the bank.

It might be worth a closer look, now the balance sheet has been fixed.

Universe (LON:UNG) - an in line update, but with an H2 weighting;

"Trading in the first half of 2016 has been in line with management expectations. The Group is currently implementing new installations for recently-won contracts and therefore, like last year, the trading performance for the full year will be weighted towards the second half.

Anpario (LON:ANP) - H1 revenues below last year, but still on track to meet full year expectations;

"The Company remains on track to meet its profit expectations for the financial year to 31 December 2016. Revenues for the first half will be below the level of last year; this is due to a number of territories being affected by geopolitical events and distributor specific trading.  Sales volumes in May and June have seen an improvement and overall margins remain strong mainly as a result of our continuing focus on improving the sales mix.  The board believes the positive momentum will gather pace in the second half.

This share has been losing its premium rating gradually, which I think makes sense given that growth seems rather pedestrian.

Note the large cash balance, reported as £10.4m at 27 Jun 2016. It looks priced about right now, to me, at 226p currently.

HML Holdings (LON:HMLH) - reasonable results out today, for y/e 31 Mar 2016. I can't directly compare the EPS to forecast, as I think forecast strips out some items, e.g. amortisation, and possibly share-based payments?

The balance sheet is looking weak, but probably not an issue because it has reliable recurring revenues. This company should be resilient in an economic downturn.

Valuation looks about right to me.

James Cropper (LON:CRPR) - strong results out today. Might be worth a look? I believe new products are driving profit growth here.

Carpetright (LON:CPR) - good results, with underlying EPS up 40.9% to 19.3p. That puts the shares on a reasonable PER of 12.6, based on the current share price of 244p (down 11.3% today, at the time of writing).

The problem is wobbly outlook comments;

We have had a challenging start to the new financial year, against strong comparatives in the prior year and in a market which is increasingly competitive.  In the UK, while May was a difficult month with like-for-like sales down 7.6%, June has been significantly better, being up 6.3%.  These figures combine to give a decline of 1.0% for the eight weeks to 25 June 2016.  In the Rest of Europe, like-for-like sales up by 1.3%, on a local currency basis over the same period.

"Trading conditions in the early weeks of the new financial year have been more challenging, against strong comparatives in the prior year and in a market which is increasingly competitive, particularly in the UK.  The outlook has been further complicated by the outcome of last week's referendum and we are cautious about the impact the associated uncertainty will have on consumer confidence. 

The balance sheet look OK, taking into account freeholds & long leases.

I like the comments about the new store format, which has been successfully trialled.

For me, at the moment, I'm only buying amazing bargains. We don't know what consumer confidence is likely to do (probably deteriorate), so I'm reluctant to buy any new retail positions.

Fastjet (LON:FJET) - yet more bad news. The company today says it needs to raise even more cash. It's total junk, and should be allowed to go bust, in my view.

Cloudbuy (LON:CBUY) - diabolical figures out today, from this joke company. How they managed to refinance, I have no idea.

Cohort (LON:CHRT) - impressive numbers out today. Adj. EPS up 33% to 27.18p.

Net funds of £19.8m. Total divis up 20% to 6.0p.

Note order book down 13% to £116m.

Outlook comments sounds a bit mixed, but generally quite positive.

There's the ever-present risk of a profit warning with this type of company, so it's probably not for me.

Right, got to dash! See you tomorrow.

Regards, Paul.

(usual disclaimers apply)