Small Cap Value Report (8 Jul 2016) - AVN, CHH, IND, JPR

8th Jul '16 by Paul Scott

46 comments 25319 reads

Good morning!

At the moment a lot of investors are asking me why particular shares have gone down, when logically they should not have done so (e.g. a company like Somero Enterprises Inc (LON:SOM) which is mainly US-based, hence its profits will translate into a higher sterling amount).

I think the answer is that we're not in an entirely rational market at the moment. We're still in price discovery mode - where the market often over-reacts on the downside after a shock to the system, then prices gradually find a level where demand & supply for each share balances out. This is a particularly chaotic process in small caps, which can move on the tiniest of volumes.

None of us know for sure what the economic outlook is going to be. It's safe to say that the UK economy is slowing, but how much, and for how long, nobody knows.

The FT today mentions that the latest consumer confidence reading has sharply deteriorated. Of course it has, that shouldn't come as a surprise to anyone. The latest reading is that 60% of people expect the UK economy to worsen, up from 46% a month ago.

If you're bullish (like me), then you probably see this as a blip, and expect to see a gentle recovery in confidence. Still a slowdown, but not turning into a recession (2 consecutive quarters of economic contraction).

If you're bearish, then you might see this as the thin end of the wedge, with the economy gradually sinking into a recession. Bears are also more nervous about the banking sector, with yet another Eurozone crisis brewing at the moment with Italy's banks, and Deutsche Bank's derivatives exposure is a big worry.

You need to have a view on the macro picture, because otherwise you can't logically make decisions about which shares to buy, hold, or sell. So it's not pointless guesswork, it's vital to our investment strategy. If in doubt, then arguably play it safe, and sit on the sidelines in cash. Whatever you decide is best for you.

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In such interesting times, I'm trying to do more CEO interviews when time permits. I've lined up the CEO/FD of staffing group Empresaria (LON:EMR) to do an interview next week. So if you wish to submit a question for me to ask, please fill in the form…

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Rusty2

8th Jul '16

I see thanks, just coming up on Stockopedia as inactive.

I also have Waterman (LON:WTM) I was annoyed I was going to sell it but someone persuaded me to hold onto it, next time I will go with my own instinct.

PhilHofGrowYourDough

You and me both spooky.

Thanks
Phil

jonesj

Hello Paul,
Thanks for keeping up the excellent articles.

Exchange rates are the one point I would like to debate. When you refer to "sterling remaining low", is that based on anchoring to last month's price ? Or some independent fair value figure ?

As far as I can see, at the previous exchange rates, all we could do was run a horrendous balance of trade deficit, exceeding 4% of GDP. Long term, we cannot have equilibrium with such a deficit. A fall in the pound was inevitable & whilst it may be unpleasant for consumers, it is what the economy needs.

For me, the real question could be is the current exchange rate too high or too low ?

Jeff

Trident

Surely if the Dollar/Sterling relationship continues for a good while, some aggressive investors are going to be piling into what they consider under-valued UK stocks, and/or for acquisitive US companies go on the acquisition trail.

With US interest rates staying low, it must be almost the perfect time for large US entities to look at the UK?

seadoc

Buyhard,

Not thick it just that it is written in a secret code! 25yrs ago I took on the VAT returns for my wife and to help did level 2 RSA book-keeping at the local Adult Education Centre. My daytime job was consultant surgeon, got to less than half of tutorials but the tutor was very supportive and with her help, past papers and helpful comments on what I handed in I scored a distinction. I could then (and only then) understand Holmes and Sudgen, an idiots guide to accounts. Amazon have the 1990 edition (the one I had!) from 1p:

http://www.amazon.co.uk/Interpreting-Company-Reports-Accounts-Geoffrey/dp/085941650X/ref=sr_1_15?ie=UTF8&qid=1467990534&sr=8-15&keywords=read+company+accounts

I also had a red book of the same era, even more simple, might have been from FT but that was lent to a friend and never returned and cannot see it on Amazon. Well worth a visit to local charity shops, they end up pulping most financial books, I had always wanted to read Benjamin Graham and picked up a copy for NZ$1 (50p), hours of entertainment!

Regards,

Seadoc

JohnEustace

buyhard,
There's a one hour video on YouTube by Bill Ackman that covers some of the basics early on.

William Ackman: Everything You Need to Know About Finance and Investing in Under an Hour
https://youtu.be/WEDIj9JBTC8

Connor Davidson

You're spot on when it comes to Avanti. It's all over.

The model here is totally broken. Satellite companies suffer from incredibly bad depreciation of their assets. There is a duel depreciation here. First the tech becomes obsolete (newer satellites have more capacity and similar fixed costs so cost per unit falls) and then the satellites fall out of the sky. Gravity attracts mass, if you don't keep pushing the satellite back it's going to fall into the ocean. Eventually you run out of fuel to run the boosters to maintain the orbit and your assets are worthless. Then earning power of the asset falls and then it dies. The business sucks.

I don't believe the debt holders will get their money back before their current fleet falls out of the sky. If there isn't enough money for debt holders equity holders get nothing. Avanti is finished.

DJLJ23

9th Jul '16

Having just heard from a friend, up here in the north, that his company is laying off 50% (40 heads) because they can no longer afford to buy the materials they need to keep in business. I'm not so sure a lower £ is what the economy needs. It will benefit companies with strong IP and probably labour based, but I think small engineering manufacturers, with low margins in highly competitive markets are going to suffer.

Brilliant Leader

I agree with your thinking/observation. I decided to get out of all low margin holdings - it just doesn't take much for such companies to get into trouble, especially in a downturn. My mindset at the moment is to look for quality; strong IP, high margins, good cash flow and low debt. This said, I'm not in any rush to buy as I think there will be some further market-wide shockwaves.

Paul Scott

10th Jul '16

Hi Connor,

I'm a bit out of the loop (geddit?!) about orbits, as I last studied Astronomy as a subsidiary subject at Uni, 25-30 years ago!

But my recollection is that when objects are put into orbit, they stay in orbit of their own accord, since the attraction of gravity from the earth is offset by their momentum to continue travelling in a straight line.

I thought the main risk to satellite was from space dust? Even tiny fragments of space junk can cause catastophic damage, as travelling at something like 20,000 mph. Apparently the space station has to track, and regularly adjust its position, to avoid collision with tiny particles which could puncture its skin.

AVN's main mistake was funding its operations with a ridiculous junk bond at 10% interest, when it had no means of paying the interest, let alone repaying capital. And price deflation for its services.

Regards, Paul.

Longer-term, I'd definitely like to run some courses to help non-accountants understand company accounts better, specifically for investing. Trouble is, like everything, it's all about finding the time. It would be an enormous project, to prepare really good quality presentations. But certainly something on the to do list, longer term. Hopefully also these SCVR articles are useful in pointing out plenty of red flags in company accounts.

The 100% losses are usually very easy to avoid, if you ignore the story that Directors are telling, and instead dissect the published numbers - which is actually quite quick & easy once you know what to look for.

Trouble is, most people don't want to spend the time or effort dissecting numbers. Instead, they want an easy to digest, positive story. Surely we've all learned by now that such stories nearly always go wrong?!

Regards, Paul.

You are right that I'm wrong on how satellites die but they do in fact effectively die. The sentence "gravity attracts mass if you don't keep pushing the satellite back it's going to fall into the ocean" isn't correct. Oops! This is quite embarrassing as I'm actually trained as an engineer! More helicopters than satellites though. Better look up my old notes and explain it properly (and correctly this time). The basic point that satellites have a short fixed useful life (and hence rapidly depreciate) is correct but the explanation of why is way off. Here goes...

Ultimately satellites will eventually end up in the ocean due to orbital decay (might take 1000+ years though). In practise, they have a fixed useful life of up to around 15 years and are limited by the propellant. After the propellant is used up you can't maintain your orbital slot or effectively point the satellite. Space isn't completely free of friction and complex gravitational effects cause a satellites orientation to drift which needs to be corrected which uses up propellant. At the end of the life of a satellite it can either be de-orbited and crash down into the ocean (reducing space junk) or be put in a graveyard orbit. You can insure away many risks like collisions but you can't insure against the inevitable fact that you will run out of propellant. Those tiny particles however cause incredible damage due to their insane speed. There is also something to do with the solar activity cycle which is a big risk but can't remember how it works.

The bottom line is that all of Avanti's current space assets will be worthless within about a decade. I think this is an extremely important point to consider when valuing Avant (historically that is as it is now screwed) and was one of the things that gave me confidence to short it (if things worked out magically it helped to limit the downside). I expect that the debt will never be repaid. The current fleet is, at best, not far off half of its useful life and most of the capacity has not even been sold yet. Every day that goes by the amount that bondholders can recover goes down as the propellant slowly runs down.

Hopefully that makes more sense and is correct this time.

Hi Connor,

Thanks for your response.

It sounds like satellites need a small, but finite amount of rocket fuel to make minor adjustments to maintain their orbit.

Also, the technology they carry will rapidly become obsolete, making the satellite commercially worthless after a few years.

Is that a fair summary?

Regards, Paul.

Yeah, that's the idea (and better explanation is here: http://www.satellitetoday.com/publications/2013/03/01/satellite-life-extension-reaching-for-the-holy-grail/). You see the double depreciation effect? Finite life + obsolescence + junk debt + huge leverage + failure to sell capacity =???

If you are not making huge returns in the early years you are in serious trouble. When Lucian says that the business model doesn't work he's right. When I asked my old lecturer (who taught spaceflight systems) about Avanti and explained that they had satellites in space for several years with less than 25% of the capacity sold he thought it was hilarious. In order to make enough money get a return over the cost of the junk debt means selling an insane amount of capacity to Africa. They launched the capacity and its not selling.

11th Jul '16

That's great.

Let's get points across in as few words as possible in future maybe?

Brevity is good.

P.

Hi DJLJ,

Your comment does not pass the truth test. You said;

BS! Any proper business would not dream of getting rid of 50% of their workforce. You made that up!

Imported things will go up in price. Businesses will have to juggle prices, and everyone will survive.

Your mate sounds like a total clown!

PP.

Paul,
I don't know the detailed planning thats behind those figures or what timescales it will be over, but I belief it was the truth and I have a great deal of respect for the individual. I believe we will see a lot more of this happening (see yesterdays Sunday times ref. business's on south coast).

So while many businesses will survive and some no doubt thrive. Brexit and the fall in the valley of the £ is going to cause real problems for some business as they may not have the leverage to juggle prices and as consequence will have to take steps to manage their business.

Which was the real point

kenobi

Interesting that some companies will prosper others suffer, I have friends working in it companies in the south east where I live. Some are telling me that many major deals are on hold, and that their budgets are all dollar denominated so they're really struggling.

Another was telling me that he's considering moving jobs into the area, from Poland, because the change in the exchange rate means that price difference of engineers here rather than Poland has shrunk to a point where it's not worth the hassle of remove working/cultural differences etc. I can't believe he's saying it's now cheaper to employ people here, but obviously there are downsides to split working and it's more productive to be based in one place with less language and cultural differences. So for people with the right skills, this might be good, for many this might be very bad. (note this company bills entirely in dollars).

My fear is that people who are in these companies having a bad time, then become cautious about spending themselves and it becomes sell forfilling that they don't spend on their houses, or on holidays, cars etc, and the slowdown becomes inevitable.

However who can see what the future exchange rate will be ? do you make decisions like moving jobs from eastern europe only to see it bounce back over 2 years ?

The uncertainty in exchange rate in itself is a problem,

buyhard

18th Jul '16

If you do ever remember the name of that book please let me know :) Now, where's my library card...

Small Cap Value Report (8 Jul 2016) - AVN, CHH, IND, JPR

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Paul Scott

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