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

Tuesday, Jan 03 2017 by

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.…

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Punch Taverns Limited, Formerly Punch Taverns plc, is a United Kingdom-based pub company. The Company is engaged in the operation of public houses under the leased and tenanted model, which involves the granting of leases to tenants operating the pub as their own business, paying rent to the Company, and purchasing beer and other drinks from the Company. The Company's segments include Core and Mercury. It has a portfolio of approximately 2,580 pubs in the Core division and over 690 pubs in the Mercury division. The Company also operates public houses under the retail operating model. The Company has approximately 110 pubs trading under retail contracts. The Company's pub categories include Community Pubs, High Street Pubs and Destination Pubs. Its pubs include Arkwrights, Black Horse, Coach and Horses, Bulls Head, Cedar Inn, Cross Keys, Castle Inn, Saracens Head, Stanley Arms, Travellers Inn, Travellers Rest, Bronte and Blacksmiths Arms, among others. more »

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Ei Group plc, formerly Enterprise Inns plc, is a leased and tenanted pub company in the United Kingdom. The Company includes a portfolio of businesses comprising a range of operating models and trading styles. Its businesses include Ei Publican Partnerships, Ei Commercial Properties, Ei Managed Operations and Ei Managed Investments. Its Ei Commercial Properties business manages a developing portfolio of assets, which it leases to third parties on commercial property terms. Its business also provides asset management support for its leased and tenanted, and managed house businesses. The Ei Managed Operations business manages approximately 100 pubs with over 30 trading under its Bermondsey operation and approximately 70 under its Craft Union operation. It also develops standalone and residential sites on land that is surplus to pub requirements. The Company has over 4,400 properties that are run as leased and tenanted pubs. more »

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Revolution Bars Group plc is a United Kingdom-based operator of bars. The Company has a trading portfolio of approximately 60 bars located predominantly in town or city high streets, which operate under the Revolution and Revolucion de Cuba brands. The Company's bars focus on a drinks and food-led offering, and typically trade from late morning, during the day and into late evening. Revolucion de Cuba bars are characterized by their 1940s Cuban-inspired style, with dark woods, traditional bar counters, antique tiles, vintage furniture, Havana-style ceiling fans, and original Cuban artwork and photographs. Its bars are located in various places, such as Cambridge, Ipswich and Norwich in South East; Bath, Plymouth and Southampton in South West; Birmingham, Derby, Leicester, Loughborough and Milton Keynes in Midlands; Cardiff and Swansea in Wales; Blackpool, Chester and Huddersfield in North West; Sheffield, Sunderland and York in North East, and Edinburgh and Glasgow in Scotland. more »

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70 Comments on this Article show/hide all

crazycoops 3rd Jan '17 11 of 70

Hi Paul

A great, thought provoking article to start the year, thank you. I doubt you will have such a luxury again once the January trading updates begin :-)

The one area you have only indirectly addressed is the GBP/USD issue. While, like you, I believe this will lead to the continuing trend for takeover bids, I also believe dollar earning, UK based companies will continue to do well in 2017 as those increased earnings come through in their results. For the time being at least, I have got a strong bias in my portfolio for companies with a large proportion of dollar earnings. If you have time, I would be interested in your perspective on this 2017 theme.

EDIT - Apologies, I thought you had finished your article when I posted this. I see that you have now added a final section on this theme, thank you.


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TMFMayn 3rd Jan '17 12 of 70

In reply to post #164500

The Franco Manca concept is a terrific, self-funding roll-out now

I am not sure it is self-funding just yet. The last H1 results showed a net cash inflow after capex due only to a sizeable increase in trade and other payables. Presumably a mix of paying suppliers a bit later and additional rent-free agreements were factors here. Whether such favourable cash management can continue to fund capex remains to be seen. Headline operating profit was £2.4m versus capex of £5.7m for the half.

The most remarkable feature of FUL's accounts is its lease cost -- just £1.3m for 2016 for 29 (at year-end) units (mostly in London) producing revenue of £29m.

A rival quoted chain has lease costs at 11% of revenue (vs FUL's 4.5%), and yet produces lower revenue per unit (<£900k vs £1m+ for FUL).

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Paul Scott 3rd Jan '17 13 of 70

In reply to post #164557

Hi Simon,

It looks like you might have missed the last section in the article - where I do talk about dollar earnings, etc.

Could be that you're looking at an older version of the article. If you refresh the page, you'll get the finished article!

Regards, Paul.

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Paul Scott 3rd Jan '17 14 of 70

In reply to post #164560

Hi TMFMayn,

When I meant self-funding, I was making the more general point that Fulham Shore (LON:FUL) is generating plenty of cashflow to fund new sites. Now it might be that they decide to go even faster, and open more sites that cashflow will cover in full. That doesn't really matter to me, in fact I'm glad they're accelerating the roll-out. If that means taking on a little debt, to go faster, then so be it. But that's a strategy choice they've made. My point remains that the business can still expand, and fairly quickly, from internally generated cashflow. If they want to go faster still, then that might involve some debt coming in, but I doubt they will need to do another equity raise. Hope not anyway.

As regards the rents, we have to be a bit careful about comparing the year end number of shops with the annual rental bill, as some will have been opened near the end of the period. Although the comparison with turnover is more valid.

I particularly like the way FUL targets quite small units, which it wants to be rammed full, all the time. This is such a smart strategy, especially as pizzas are so quick to make, cook, and then eat. So the customer turnover must be pretty rapid I reckon.

I bought shares in it, after visiting their Brighton branch of Franco Manca, which had not been open long, yet was obviously extremely popular - offering very good value for money, tasty pizzas, etc. The craft beer was superb, and great value, I thought.

Cheers, Paul.

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cafcash49 3rd Jan '17 15 of 70

Hi Paul, Happy new year. Great posting this morning which I have read and digested in full. Over the holiday I was reading somewhere about PEG as a metric which I always look at. The suggestion was a PEG in xs of 3 was a sell signal. I am therefore making that a rule for me, sell when the PEG goes over 3. I found I only had one in xs of 3 and that is D4t4 Solutions so I am going to sell. Am I being too rigid here or is this rule a good idea in your opinion?

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Aislabie 3rd Jan '17 16 of 70

Paul, firstly thank you for this and all your work in 2016. I find much to agree with in your analysis and others to go back and think about. But the one that I find really difficult is the UK motor dealer enthusiasm.
If we are to have some inflation, and I agree that it looks very likely, then cars are one if the first things to come out of discretionary spending. The argument that rolling 3 year leases have made car sales an almost guaranteed recurring income is not one that I buy, at least not anywhere near enough to buy car dealers while car sales are at a high.

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simoan 3rd Jan '17 17 of 70

In reply to post #164569

Over the holiday I was reading somewhere about PEG as a metric which I always look at. The suggestion was a PEG in xs of 3 was a sell signal. I am therefore making that a rule for me, sell when the PEG goes over 3. I found I only had one in xs of 3 and that is D4t4 Solutions so I am going to sell. Am I being too rigid here or is this rule a good idea in your opinion?

This is just my personal opinion, but I find it pretty extreme to decide to sell based on a single metric, especially one which is based on brokers EPS estimates and particularly where there are very few brokers making estimates, as there are with most small caps. Over to you though. Good luck whatever you decide! :)

All the best, Si

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goingbroke 3rd Jan '17 18 of 70

Hi Paul, I wonder why you see some retail rollouts such as CAKE are different to retailers. They are pretty tied into the success of the high street, which you seem to think is under attack from online and in decline (i.e. Decreasing footfall)?

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Paul Scott 3rd Jan '17 19 of 70

In reply to post #164578

Hi goingbroke,

I feel that High Streets are becoming leisure destinations, as opposed to just somewhere people go to buy stuff - i.e. more people seem to be going into town to meet with friends, have lunch, etc, rather than just to buy clothes or shoes. They might do some shopping too.

Furthermore, I've visited various Patisserie Holdings (LON:CAKE) branches, and done my own research on the food & drink offering, and I think it's an absolutely excellent format. Their English Breakfast Tea (loose leaf in a little pot) was out of this world! Not so keen on their coffee, mind you.

It's just a great format, their sites seem to be busy all the time, and I really like the financials too - very profitable & cash generative, good balance sheet, I just like everything about it. Would have liked to buy on a PER of less than 19, but in the end gritted my teeth & pushed the buy button.

Regards, Paul.

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ISAallowance 3rd Jan '17 20 of 70

Hi Paul,

Another retail roll-out that I don't recall you ever covering (probably way too big for your normal coverage) is B&M European Value Retail SA (LON:BME). Very much self-funding, P/E about 20 now having risen somewhat in the last few months, and IMO fairly defensive if the economy turns sour. My local one is always packed. I think they are about 500 shops into their 850 store UK target, which would limit potential upside, but there is also the possibility of considerable expansion in Germany. One downside is a Luxembourg domicile resulting in approx 15% tax on divis.

They do seem to equate an "efficient balance sheet" with deliberately running maybe a bit too much debt IMO (2.25 x EBITDA from memory, may be wrong).

(I have a small long position)

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FREng 3rd Jan '17 21 of 70

Great article, Paul. Very thought provoking.

Personally, I'm alarmed by the market valuation (especially in the USA, against most historic measures) and by the growing feeling that the market believes that Brexit will have a positive effect in the Uk and that Trump will have a positive effect in the US. There's a disconcerting sense of euphoria in the air.

I shall review my holdings to decide which ones I would be happy to continue to hold for 5 years if the prices halved in a market crash.

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simoan 3rd Jan '17 22 of 70

Hi Paul,

I would beware letting books and other people's opinions colour your own opinions too much. The only books I read on investing these days are about behavioural economics and psychology which I have found incredibly helpful to my own approach, particularly the James Montier book which I read on a regular basis lest I forget any of the nuggets contained therein, which I am wont to do. 

Certainly, Gervais Williams has had a good run the past few years at Miton, there's no doubt, but as an unfortunate former holder of Gartmore UK & Irish Smaller companies fund many years ago, I personally would take his opinion with a dose of salt. It's performance was not great and was one of the major reasons for deciding I could invest in small caps better on my own. If 2016 as a year represented anything, for me it was the year of the death of the expert. As an engineer I will stick to facts, which is increasingly difficult in a post-fact, talking-head, expert obsessed world, and the real fact is that no-one knows what is going to happen in 2017, or beyond. All I know is that I am going to stick to companies that have good margins, generate cash and have strong balance sheets. 

I find your thoughts really interesting as always and some of them follow my own. However, I'm a little confused why you would hold Purplebricks (LON:PURP) if you believe interest rates could rise and there will likely be a property recession? Surely this scenario would throttle growth even if they are taking market share from bricks and mortar estate agents? So I assume this is not a long-term, high conviction hold for you.The same applies to car dealerships, if you believe interest rates are going to rise and house prices fall I cannot see car sales doing anything other than plummeting? I'm glad to have got a bargepole extension for Xmas :)

Maybe I've misinterpreted what you meant? Your thoughts on the outlook for interest rates and property are similar to my own, and I don't have any exposure to property shares other than a very small residual holding in McKay Securities (LON:MCKS) which is already at a significant discount to NTAV (a bit like the pub companies you mention) and so is mainly held for the 5% yield. I am also thinking of dumping all my fixed interest rate investments (mainly bank prefs) at the first signs of interest rates rising in the UK.

Whatever happens in 2017, let's hope it's another profitable one!!

All the best, Si

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Ups1de 3rd Jan '17 23 of 70

Paul, as ever thank you for a thought provoking article. Never has it been more necessary for us all to remember to in a ' market of stocks' rather than s stock market. Selectivity will be key especially when you consider the macro backdrop for the U.K. In 2017: Inflation RISING; GDP growth FALLING; Interest rates likely to RISE;Local Currency DEPRECIATING against main trading partners . Be careful... and picky out there !

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CrazyHorse 3rd Jan '17 24 of 70

Hi Paul - thanks for the consistently intelligent, thought provoking words here and over the last year. It really is appreciated.

Are you thinking of doing any more web-chats with the old favorites (Leon Boros, Richard Crow and other) again this year?

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goingbroke 3rd Jan '17 25 of 70

In reply to post #164581

Thanks Paul that makes sense, I guess I'll just have to try one now to see if your right!

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purpleski 3rd Jan '17 26 of 70

Thanks Paul for a truly brilliant article, which is too long for me to read all of now but will do so this evening.

Happy New Year.

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troytea 3rd Jan '17 27 of 70

Thanks Paul,

I do enjoy reading your musings and your take + reasons for them on 2017 - it certainly widens my own views on potential share targets. Cheeky ask, if Graham is reading, I wonder if he can share his views in his own distinctive style.

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Trident 3rd Jan '17 28 of 70

Very much back the view that Stockopedia is a great filter. It allows me to second guess my own choices, which is really necessary.

I agree with Paul that the takeover premium will again play out in 2017. However, hard to predict how that will individually apply. Undervaluation is a good starting point. I am in Revolution bars, so am tempted to let that run for a good while.

I am also in Tracsis which frankly isn't undervalued, but has great potential if it can take advantage of its very high margins to grow the top line, and benefit the bottom line. Maybe they need a year off acquiring to squeeze the benefits of their existing businesses?

Very much interested if Paul is going to do a catch up interview with their CEO in early 2017?

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SmallCappy 3rd Jan '17 29 of 70

Paul excellent overview

Couple of thoughts from me (2 is always my limit)

1. Purplebricks - conventional estate agents are launching similar services alongside the traditional estate agency service so that may be something to be aware of

2. home automation is going to be big. I am not sure who to back apart from the giants - Amazon and Google - and British Gas have a nice offering in its Hive system which I am about to have installed. I hold a long position in Telit (TCM) which should be a beneficiary of the Internet of Things generally. If you go on Amazon and look at any of the standard Smart Things products they are pretty much out of stock. As an aside I have just set up a system on my MacBook to automatically switch the charger on and off when battery levels hit predefined values. I only mention this as it has been a real ballache!

All the best to you and yours in 2017


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kenobi 3rd Jan '17 30 of 70

great article Paul, happy new year by the way,

I would make a couple of observations though, first, you make a point of avoiding property, both commercial and residential. Very sensible at these levels, however then you suggest pub chains because they're at a big discount to NAV, however that nav would be mostly commercial property ? fair enough though if it's a big discount but if we hit a recession, and profits fall, that discount might prove to be a mirage, I agree there's potential for a takeover.

Also you are avoiding retailers, but resturants/cafe etc, have at least some of the issues of the retailers, living wage, and some higher costs from imports.

Great ideas though will check some of them out ,


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About Paul Scott

Paul Scott

I trained as an accountant with a Top 5 firm, but that was so boring that I spent too much time in the 1990s being a disco bunny, and busting moves on the dancefloor, and chilling out with mates back at either my house or theirs, and having a lot of fun!Then spent 8 years as FD for a ladieswear retail chain called "Pilot", leaving on great terms in 2002 - having been a key player in growing the business 10 fold. If the truth be told, I partied pretty hard at the weekends too, so bank reconciliations on Monday mornings were more luck than judgement!! But they were always correct.I got bored with that and decided to become a professional small caps investor in 2002. I made millions, but got too cocky, and lost the lot in 2008, due to excessive gearing. A miserable, wilderness period occurred from 2008-2012.Since then, the sun has begun to shine again! I am now utterly briliant again, and immerse myself in small caps, and am a walking encyclopedia on the subject. I love writing a daily report for on most weekday mornings, constantly researching daily results & trading updates for small caps. Cheese! more »


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