Small Cap Value Report (3 Jan 2017) - my investing themes for the year

Good morning!

There's literally nothing on the RNS today, in terms of results or trading updates for my universe of stocks. However, I'm in the mood to write an article, so thought I'd do something on my investing themes for 2017. This has been partly stimulated by me reading Gervais Williams' latest book, "The Retreat of Globalisation" over the holidays - which is an interesting macro overview of how Gervais sees things developing.

My approach with stock-picking is based on trying to find value & GARP (growth at reasonable price) shares. I look for shares with at least 50% upside, which are either;

• Fundamentally under-priced as things stand now. Good examples last year were Lavendon, and Avesco, both of which just seemed the wrong price to me, as highlighted in these reports. They both attracted takeover bids, which was terrific.
• Or, companies which may not look particularly cheap right now, but which have the potential to significantly out-perform against unreasonably pessimistic broker forecasts (a good example was Gear4Music, in which I hold a long position). And/or companies which are growing strongly, but this has not yet been fully reflected in the rating.

However, for me personally, I will flex my approach somewhat to suit market conditions. This has involved a notable shift in 2016 from value shares, more towards growth stocks. I've done that partly because my value shares kept attracting takeover bids, hence left the market, and giving me fresh (and increased) funds to invest. Also because it was increasingly obvious as 2016 progressed that it was the growth stocks which the market was getting excited about, and were rising in price. So if you spot a clear trend, then it makes sense to follow it - providing valuations don't get too bonkers.

Anyway, it worked well in 2016. Although I don't know whether the same trends will continue in 2017 - anything could happen. That uncertainty is why I don't tend to think too much in top-down terms. I can't possibly forecast what the world, or UK economies will do in 2017 and beyond, I haven't got a clue - and nor has anyone else!

However, there are some clear themes which are guiding my thinking for 2017. So I thought it would help clarify my thinking, and maybe you might find it interesting. So here goes.

My investing themes for 2017

Higher inflation - caused by the sharp fall in sterling against the dollar. This increases the UK cost of imported goods, which are often priced in dollars. So I'm expecting UK consumers to become even more price-conscious. Also companies are already facing a battle with suppliers, over how the pain is shared. So importers are likely to face a squeeze on their profit margins.

Bank lending - although higher inflation might be somewhat offset by a willingness of households to borrow more, as memories of the 2008 GFC begin to fade. Banks seem to be relaxing lending criteria from what I've noticed, subjectively.

Retailers - are being squeezed from all directions - higher cost of goods sold due to weak sterling, relentlessly increasing wages cost (due to Living Wage), the apprenticeship levy, pensions contributions, etc. Business rates are set to increase a lot in London & major towns/cities. Online is still growing very strongly, taking business away from the already embattled High Street.

This combination of factors seems horrendous to me. So I'm trying to avoid retailers altogether. My only exception is Debenhams (LON:DEB) (in which I hold a long position) where I am hoping the new, ex-Amazon CEO could reveal an internet-focused strategy that might trigger a re-rating.

Leisure - consumers seem to want less stuff now, and instead are more willing to spend on meals & nights out. So I like the following stocks;

Punch Taverns (LON:PUB) (in which I hold a long position) - the market overlooked the immense discount to NTAV for some time. However, 2 potential bidders (including Heineken) did spot it, and the company is now in play - i.e. likely to be taken over. The shares have more than doubled in the last 6 months, but are still at a hefty discount (about a third) to NTAV. As one analyst pointed out, to build an estate of this quality from scratch would take about 20 years, and would cost more than NTAV. So it's an obvious takeover candidate. Refinancing its debt pile onto lower interest rates could transform profitability over time. Also, higher inflation means that, over time, the debt pile would become less of a problem.

Enterprise Inns (LON:ETI) (in which I hold a long position) - this is almost the same as Punch, just double the size. So potential bidders could surface here too. Hence I'm hoping for a second bite of the cake with this one. The share price is at a discount of almost 50% to NTAV. As with Punch, the issue here is that there's a lot of debt. Although I reckon the market may be shifting from seeing that as a problem, to an opportunity (to refinance it more cheaply).

Revolution Bars (LON:RBG) (in which I hold a long position) - a much smaller, but growing bars group. The key difference here is that, amazingly, this bars group is completely debt-free. It leases, rather than owns, its sites. However, if you dig into the numbers, you'll find that the company achieves very high gross margins, and is expanding into sites which are on cheap rents. This means it's very nicely cash generative. So this is now a straightforward retail roll-out, entirely self-funded from cashflow. The forward PER is only 12.6, which I think is far too cheap. For new sites, the return on capex is nearly 40%, which is fantastic.

This brings me on to;

Retail roll-outs - I love a good retail roll-out. This is where a successful, profitable smaller retailer just opens lots of new sites, thereby growing its profits, even in a stagnant economy. The best ones are self-funding - i.e. the cashflow generated from existing sites is recycled into funding new store openings. This has the effect of snowballing profits, as fixed costs are diluted from more & more shops. In practice, fixed central costs are really stepped costs - so they do increase, just not as quickly as gross profit.

So with a good roll-out, you have a lovely combination of a rising top line (from new store openings), together with a rising operating profit margin. That can have an explosive impact on profits, over a few years.

For this reason, when the market spots a good retail roll-out, the rating can become very warm - well into the 20s for PER is not at all uncommon. I think that Revolution Bars (LON:RBG) has the potential to get a really good re-rating from its current forward PER of 12.6.

Also, I like;

Patisserie Holdings (LON:CAKE) (in which I hold a long position) - this one is a lot more expensive (forward PER of 19.2), but it's a great format, and is also debt-free. Luke Johnson owns 38% so you just know it's going to do well over the long term. I only recently bought into this share, around 300p-ish, but intend holding forever - or at least providing the valuation doesn't get too crazy. I suspect growth is likely to be augmented by acquisitions too.

The other thing to consider with roll-outs, is that the High Street is now under so much pressure, that plenty of empty sites are likely to appear. RBG has already said that it is being offered very good sites, at low rents, and with deals (e.g. long rent-free periods). Therefore, this is a particularly good time to invest in any retail formats (shops, bars, cafes, restaurants, etc) that are expanding. They're spoiled for choice in terms of new premises, and can get great deals.

I think High Streets are changing, and becoming much more leisure destinations. So it makes sense to find the best, expanding operators, and jump on board, in my view. I see 2017 being a bloodbath for independent retailers, and maybe some big names too. Something has to give, as there's not enough business to go round, and rents are far too high in many cases.

Yet the 5-yearly upward-only rent review system doesn't allow for rents to adjust downwards, until either a lease expires, or the tenant goes bust. So I think there could be a long & painful period of weaker retailers going under. I certainly wouldn't be investing in any property companies with significant exposure to retail premises, either. Sooner or later I imagine they're likely to see a lot of downward pressure on rents. Combine that with likely increases in interest costs, and it may not be a pretty picture at all.

Fulham Shore (LON:FUL) (in which I hold a long position) - my attention is drawn to this casual dining chain, by reader Billytk in the comments section below. This is another classic retail roll-out. Management are very experienced, and I think they've hit the jackpot with their Franco Manca pizza chain. It's very popular, and affordable, with some excellent innovations, such as own-brand (and delicious!) craft beers at £3.50 each. Also free jugs of tap water when you first arrive. Smallish sites, deliberatively, which are always busy. Happy, incentivised staff (based on my conversations with them, when trying out their pizza). A winning format in my view, although the shares look pricey for now, but retail roll-outs usually do.

Richoux (LON:RIC) (in which I hold a long position) - a tiny, and obscure little cafe & restaurant chain. I've been saying for years that it needed new management, and my wish has been granted. Highly experienced new management have been given a massive slug of equity, in return for a plan to transform the business. A horribly illiquid share though, so probably best avoided. I bought some on impulse, and paid far too much for them, but will hold for 5 years, and see what happens. I did very well out of Prezzo a few years ago, and it's the same guy who's taken over Richoux.

Online disrupters - it's becoming increasingly obvious that more & more sectors are being turned upside down by internet companies. These are often intermediaries between customer and supplier (e.g. holidays, insurance, property, etc). Or straightforward retailers operating on the internet only.

The growth at these companies can be staggering (e.g. ASOS (LON:ASC) or Boohoo.Com (LON:BOO) ). However, many more me-too type of operators fail to achieve scale, and go bust. Others do achieve decent scale, but are burning so much cash that they also go bust (e.g. Nasty Gal in the USA, which BooHoo is now trying to buy - its customer list & brand anyway, wisely not its overheads).

Based on its figures to date, I reckon Koovs (LON:KOOV) could well ultimately fail, if investors tire of pouring cash into it, to fund heavy losses. If you look back at the history of both Asos & BooHoo, they didn't burn cash like Koovs. They were profitable very early on - hence little to no fresh cash was needed from investors, meaning that the share price goes through the roof, as there's little dilution.

A year or two ago, I wouldn't have even considered investing in something like Purplebricks (LON:PURP) (in which I have a long position). However, I've looked carefully at the investment case there, and it does make sense, if you can cope with the apparently huge valuation in advance of profits.

Trying to value internet disrupters on their current PER is completely missing the point. Look at how many of us thought Asos or Rightmove were ridiculously expensive during their strong growth phases. We missed out on spectacular, life-changing profits, by being blind to the bigger picture - of how these businesses would dominate their sector, and rapidly grow into the high valuation.

I think one has to be highly selective, as many attempts to disrupt new markets will end in failure. However, I really like the strong margins, up-front cashflow, big cash pile, ambitious management, and apparently market-leading market share (compared with the many smaller online competitors).

These internet disrupters are often in a winner takes all position. So if we see a winner apparently emerging, that can perhaps be a time to throw away the valuation rulebook, and just dive in. That's my view with PURP anyway. If it does come to dominate the sector, then the current £350m valuation might look crazily cheap in say 5 years' time. Or it might not, we don't know how things will turn out. So this one is very much speculative at the moment. Although if you look at the figures, it has already proven up its business model - it's near enough to breakeven, and has plenty of marketing firepower to out-spend smaller competitors. Marketing spending is absolutely key in the early stages. Without a big marketing budget, new entrants don't tend to get anywhere meaningful.

$TWTR (in which I hold a long position) - this is totally unique in the social media world, and in my view has immense latent value. So my wild card for this year is the possibility of Twitter being taken over. I don't think growth matters very much here. It's all about the value that could possibly be monetised from its 100m "power users" - high value, often professional people, who are intensively engaged with their personal network on Twitter. Again, you can't value it on conventional metrics - well you can, but that won't necessarily reflect what it's worth to an acquirer. So I am hoping for a change of management, and potential sale of the business in 2017. A bit of a wild card this one, and it's outside my comfort zone, so it will probably be a disaster!

Property - personally I don't want any exposure to the UK property market - residential, or commercial. For residential, there have been a series of negative (for prices) moves by Government - hiking Stamp Duty, ending the Help to Buy scheme, tax attacks on buy to let landlords, etc.

Also, the UK's attitude to property prices has become utterly manic, in my view. People are conditioned to relentlessly rising prices, and there's a widespread view that property prices are a one-way bet. Whenever people think like that, then there's a heightened risk of a correction. We saw it when the 1980s property bubble burst, and I reckon it's only a matter of time before the current party ends badly.

Although the key determinant is;

Interest rates - UK interest rates tend to broadly follow the US, in the long term. So with US rates apparently now on a gentle upward trajectory, the same is likely to be the case here.

However, the potential disaster scenario is if there's a major run on sterling. I was reading an article over the holidays about how Brazil (a large economy now) experienced exactly this problem of a collapsing currency, and was forced to jack up interest rates to now around 14% in order to stem the flow. That caused a horrible recession.

I'm not saying that the same is likely to happen here, but who knows? We saw interest rates of 10-12% in the early 1990s, and I remember it well. Property prices dropped 30-40% in most areas, leaving lots of people in negative equity for c.5 years. Just because we have become accustomed to ultra low interest rates, doesn't necessarily mean it will stay like that forever.

For this reason, I just don't want any exposure to assets which have become inflated in valuation due to ultra low interest rates. Although you could easily come back with the retort that shares have also become overvalued due to low interest rates. Which is true.

My hunch is that UK property prices may have peaked now, and hence it's not a sector I want any exposure to. I'm currently shorting Foxtons (LON:FOXT) because I reckon their profits could be hit very hard, with the London market already slowing.

Other estate agents look incredibly vulnerable to both a downturn in property prices, and online disruption from the likes of PURP. I struggle to see how conventional estate agents will be able to maintain their expensive branch networks, when online competitors can so drastically undercut them on price. Estate agency has been a gravy train for years, which is hitting the buffers now, in my view.

Expensive growth stocks - with my roots in value investing, I find buying growth stocks very difficult, as it goes against the natural grain.

I feel that, with economic conditions perhaps getting tighter in 2017, then growth companies will really need to deliver stonking trading updates, in order to justify a growth rating (which I would define as a PER of more than about 17).

In my view there's a risk that investors may be over-paying for quite ordinary businesses, just because they've had a couple of good years. So to my mind, if a stock commands a big PER (over 20), then it's absolutely got to have bulletproof growth potential, and be issuing strong trading updates. If not, then I'm not interested.

In his book, Gervais reckons that corporate profit margins have peaked, and are likely to fall. If he's right about that, then we could see some of today's stars on high PERs come crashing back down to earth, if they disappoint in any way with reduced profits.

Buy & builds - this has become an increasingly popular corporate strategy in 2016. It makes a lot of sense when debt is dirt cheap, to gear up with bank debt, and buy lots of businesses. This should lead to rapidly rising profits, and hence a buoyant share price. Management can then scoop out plenty of cash for themselves, having apparently delivered shareholder value.

However, as Gervais points out in his book, what happens when the tide goes out? That type of geared business ends up with the double-whammy of collapsing profits, and a jittery bank with too much exposure to a business with a weak balance sheet.

Typically it also then transpires that the acquisitions weren't quite so good after all, the intangibles have to be written off, and there's a threadbare balance sheet. If banking covenants are breached, which they often are in this type of scenario, then shareholders may end up with a 100% loss, or a discounted fundraising which dilutes away most of their original stake.

I've always been very disciplined about balance sheets, so if the economy does indeed do badly, and interest rates rise, then my portfolio should hold up better than others who are less vigilant about debt & balance sheets generally.

A group with debt of "only" say 2x EBITDA might look conservatively financed now. However, if profits halve, then it's on 4x, and has probably breached its banking covenant - making debt technically repayable on demand. That's a scary thought. Gervais reckons that the managerial class are far too casual about the risks from debt, and I agree with him.

So generally, I am redoubling my efforts to avoid companies with weak balance sheets & too much debt, just in case the economy & profitability do deteriorate in future.

Takeover bids - is there an M&A boom underway? It certainly feels like it! The whole of the UK seems to be up for sale, and overseas companies are taking advantage of weak sterling to snap up decent UK companies.

In 2016 I saw 5 companies in my portfolio receive takeover bids, mostly at a decent premium too. This is a happy spin-off from picking good value stocks.

With debt still very cheap, I'm expecting more takeover bids in 2017. So when looking at any share, the potential for a takeover approach is always in the back of my mind.

Operational efficiency - sorry to keep harping on about Gervais's book, but there are lots of good points in it. He expects corporate profits to come under pressure in 2017 & beyond. He reckons growth potential is likely to be limited, or even negative, in a stagnant economy. Therefore many (particularly larger) companies will have to maintain or grow through stripping out bloated costs, which have been tolerated during a more buoyant period of economic growth.

He also points out that the usual creative destruction of recessions, and corporate failure, has largely been avoided through ultra-low interest rates. This therefore means that many companies have survived, which probably shouldn't have done. In tougher conditions, the winners will therefore be those companies which can strip out cost, and streamline/automate a lot of processes.

I've heard a couple of interesting investor presentations recently, which covered the same point. There are still many companies which do things in a remarkably inefficient, manual, way in their back offices. Future winners are likely to be companies which effectively automate those manual processes, ending up with higher profit margins.

So I'm on the look out for companies which are clearly efficient, and are doing their customer service really well, using automation. In this regard, I ordered 3 pairs of trousers from BooHoo last night just before 6pm. The company was offering £1.50 for next day delivery, which was enough to tempt me to start ordering arguably age-inappropriate skinny jeans. But what the hell, why should fashionable trousers be reserved just for skinny youngsters?!

Since then I've had a series of automated emails, telling me exactly where my trousers are, and it looks like I should have them by lunchtime. Why go to the High Street, when you can order cheap & cheerful garments from an App, which turn up by courier just hours later?

One of the reasons I'm so keen on Gear4Music (in which I hold a long position) is that management have heavily prioritised IT, and customer service. Same with BOO. Those are absolutely key areas for online retailers. If your customers are surprised & delighted with the product & service, they come back to you time & time again. This enables successful companies like G4M and BOO to actually reduce the heavy marketing spend after a while. This increases profits, and gives those companies the lovely option of being even more aggressive on selling prices (to snuff out competition), or to just enjoy rapidly growing profits.

BOO was spending about 13% of turnover on marketing, but has decided to reduce that, and instead lower its selling prices. That strategy is working a treat.

G4M is spending about 9% of turnover on marketing, from memory. Again, as it grows, and gains market share across Europe, then eventually it will be able to reduce that marketing spend, and suddenly we'll see much better profit margins, I reckon.

Eurozone problems - problems with the single currency seem to come in waves. We've not had a big panic for a while. However, the underlying problems haven't gone away, and could easily resurface any time.

I recommend reading former Governor of the Bank of England, Mervyn King's wide-ranging book, "The End of Alchemy". He's very direct in his criticism of the single currency. He seems to believe that, as currently structured, it is doomed to inevitable failure. The reason being that it has simply further distorted world trade, fuelling Germany's vast trade surplus, through providing Germany with an artificially weak currency.

So the natural mechanism by which trade imbalances are corrected (exchange rate adjustments) has disappeared. This has impoverished southern Europe, and means the only solution is to break up the Eurozone, or for Northern Europe to permanently subsidise southern Europe, in particular writing off so much debt that it would cause the whole financial system to collapse.

Therefore, arguably the Eurozone is simply in an uneasy truce, before all the problems kick off again. So I do think we should watch things carefully. Personally I won't be afraid to move into cash, if it looks like another major banking crisis is on the way.

Car dealers - mentioned here before many times. These look great value, with very low PERs. Sure, demand for new cars seems to have fallen a bit, but that's not the main profit driver.

Interestingly, if you look at the sterling:Euro exchange rate, it has improved from the lows. Sterling is now back to what it was in 2013, when measured against the Euro. So we're not in uncharted territory at all. Car dealers were nicely profitable in 2013, when the £:Euro exchange rate was the same as it is now. So why should their profits suddenly collapse this year? I don't buy it. In my view this sector is cheap, and a lot of the smaller ones have nice balance sheets too, with plenty of freeholds.

UK exporters & dollar earnings - another very important theme. With sterling still very weak against the dollar, this has made UK exporters much more competitive. It's true that raw materials priced in dollars will offset some of the gain, but the value added in sterling should feed through to higher sales & profits.

I feel this big competitive advantage has more than offset any potential risks from Brexit, so personally Brexit is not a worry for me.

Companies listed in the UK which have dollar earnings, are also very attractive right now. That's why the FTSE100 is making new highs. So I'm sitting tight on nice dollar earners & exporters like Somero Enterprises Inc (LON:SOM) and Zytronic (LON:ZYT) (I hold long positions in both).

I feel it is vital to understand a company's geographic spread of activity, so that's an area of focus when reading all company reports.

In conclusion

The above is just my personal view, illustrated with stocks that I hold personally. So obviously I'm talking my own book - if I like a share, I buy some - which seems a sensible way to operate.

As we always say, please do your own research. I don't want the hassle of people blaming me if my stock picks go wrong, which inevitably some will. Therefore please always regard my articles as pointing out shares I like, but NOT recommending, or urging you to do anything. It's your money, so buy/sell decisions are entirely your concern, not mine.

Another point is that cutting out most of the speculative stock ideas has greatly improved my performance. StockRanks are a great help in this regard. I very rarely buy shares with a very low StockRank, and I'm sure that has helped. A StockRank of say under 30, is really the Stockopedia computers talking to me, saying "Don't buy it!". That's very useful. I have to have a very, very good reason to overrule the sense check that the StockRank gives me.

In 2015 my win:lose ratio was 60:40. With a more disciplined approach in 2016, mostly keeping away from the speculative, jam tomorrow stuff, that improved to about 78:22 win:lose ratio, which I'm delighted with.

Let's hope 2017 can be another good year, although reversion to the mean suggests that Beam Me Up Scotty is very unlikely to perform as well as it did last year!

Wishing everyone a healthy, happy, and prosperous year,

Paul.

(usual disclaimers apply)